Generally, parents will make every attempt to give their children a better life than they had. This can be seen in all aspects of life whether it be home life, education, general wellness and our focus today, financial. Children on the other hand, typically don’t care too much for finances until they reach adolescence. At which point, many children become more independent. They start to understand that things cost money and that they don’t have any.
Luckily for them, being the great parent that you are, you’ve decided early on to start saving for them. You are now able to buy them a car and let them begin working and learn all of the invaluable lessons that come along with part time jobs. Maybe you’ve even saved enough to pay for them to go to college. And maybe you’ll have enough to help them purchase their first home.
Doing these things for your child opens the door for positive financial conversations. These positive financial conversations can spark an interest in your children that may benefit them for the rest of their lives.
What are my options?
There are a lot of ways you can start saving and investing for your children. Saving and investing is not a one size fits all operation, the goal of this post is to give you as many options as possible. As with most things investing, a long time horizon is ideal. Proper planning while your children are young will give them the best chance for positive investment returns. The chart below shows the growth of $1,000 – $15,000 earning a 7% return over the span of 5 – 25 years.
UTGA and UTMA Accounts
UTGA and UTMA accounts are custodial accounts named after the laws they’re based on. Uniform gifts to minors act and uniform transfers to minors act, respectively. Being custodial accounts, they are held in the name of a minor but controlled by a custodian (usually a parent or other relative) until the minor reaches an age of majority. The age of majority is designated by your state, typically between the age of 18 and 25 (sometimes referred to as the age of trust termination). Contributions made to these accounts are with after-tax dollars and are not tax deductible.
UTGA vs UTMA
The primary difference between these two types of accounts is the allowable assets for each. An UGMA account is the original custodial account and is limited to financial products such as stocks, mutual funds, bonds, cash, insurance policies, etc. An UTMA account can hold physical assets such as real estate, patents, cars, art and all of the same products that can be held in an UGMA account.
**Some states have not adopted the newer UTMA account and may not be available to you.**
Advantages:
- The money contributed into the account is exempt from paying a gift tax, up to the 2021 maximum of $15,000.
- The taxes owed on the first $1,050 of realized gains will be tax free. The next $1,050 will be taxed at the minor’s tax rate. The amount above $2,100 will be taxed based on kiddie unearned income tax rates.
- The custodian may withdraw money at any time for the benefit of the minor. These benefits must be for costs other than food, shelter and clothing and may include expenses such as education, sporting activities and summer camps.
- Easy and free to create an account when compared to a potentially more complicated and costly trust.
- When the minor takes possession, the funds can be used for anything, not just education expenses (also a potential disadvantage).
- Assets in these accounts may be protected from creditors and bankruptcy provided that the account has been used correctly.
Disadvantages:
- These accounts are reported as a child’s asset when it comes time to apply for financial aid. The child’s aid eligibility will be reduced by 20% of the assets value.
- Taxes will be owed on any realized income including dividends, interest, etc. (Up to 37% based on kiddie unearned income tax rates).
- When the minor takes possession, the funds can be used for anything, not just education expenses (also a potential advantage).
- The account will be part of the custodians taxable estate until the minor takes possession.
- You cannot transfer the account to another minor or beneficiary.
- Gifts in excess of $15,000 per year require a form to be completed for the IRS and must also be counted toward the individual’s lifetime gift-tax exclusion limits.
Child owned Roth IRA
A child owned Roth IRA is similar to a custodial account in that the decisions such as contributions, investments and distributions are made by a custodian until the child reaches the age of majority. At that point, the assets must be transferred to a new account in the child’s name. While this type of account has no age restriction, it does have income restrictions. Contributions are made to this account with after tax dollars and all growth within the account is tax free.
**A traditional IRA may also be opened for a child. A traditional IRA operates similarly to a Roth except money contributed to a traditional IRA is tax deductible. In this case, being a custodial account, the deduction will apply for the child, not the custodian. Because of this tax deduction, money withdrawn from a traditional IRA at retirement age will be subject to taxes. Contributions made to a traditional IRA are not able to be withdrawn tax and penalty free as they are with a Roth IRA. Withdrawals can be made for specified purposes such as first time home purchases, higher education costs and medical emergencies.**
Advantages:
- Tax free growth within the account.
- Contributions can be withdrawn at any time for any purpose.
- Capital gains can be used to cover higher education costs, buying a first house or certain emergencies.
- No minimum age requirement.
- Retirement account balances are not included as assets on the FAFSA. Withdrawals from a retirement account need to be reported on the FAFSA as income from the prior year. If a distribution from a Roth IRA is made during a students sophomore year (high school or college), it will not be reported on the FAFSA since the income is reported from the prior year.
- When the minor takes possession, the funds can be used for anything, not just education expenses (also a potential disadvantage).
Disadvantages:
- Children must have earned income for the year. Contributions are limited to $6,000 (2021 limit) per year or the amount of earned income, whichever is less. This income can come from babysitting, lawn mowing, modeling, etc.
- Capital gains withdrawn before age 59 ½ will be subject to a 10% early withdrawal penalty (exceptions apply).
- When the minor takes possession, the funds can be used for anything, not just education expenses (also a potential advantage).
Roth / Traditional IRA
Rather than open a custodial IRA for your child, you can open one for yourself. All the same rules apply as a custodial account, except that the account will not transfer to a beneficiary at the age of majority.
Advantages:
- Full control of how the money is used.
- A way to save for yourself and children simultaneously.
- Retirement account balances are not included as assets on the FAFSA. Withdrawals from a retirement account need to be reported on the FAFSA. If a distribution from a Roth IRA is made during a students sophomore year (high school or college assuming the student graduates in 4 years), it will not be reported on the FAFSA since the income is reported from the prior year.
- If using a traditional IRA, contributions are tax deductible.
Disadvantages:
- The money will not transfer to a beneficiary at the age of majority.
- Required minimum distributions at age 72.
- $6,000 annual contribution limit (2021).
529 College Savings Plan
529 plans were named after section 529 of the Internal Revenue Code. These are state sponsored plans but you are not limited to invest just in your state’s plan. Generally speaking, you could live in New York, invest in a Texas 529 plan and send your child to school in North Carolina. There is somewhere around 6,000 colleges and 400 foreign colleges that accept 529 plans. Contributions made to a 529 plan are made with after tax dollars. Some states do offer income tax deductions or tax credits, you may need to invest in your home state’s 529 to claim the benefit though. Funds grow tax free inside the account and are also tax free when withdrawn for qualified education costs.
Advantages:
- Tax free growth and withdrawals for education expenses. Qualified withdrawals may include tuition and fees, books and materials, room and board (for students enrolled at least half-time), computers and related equipment, internet access and special needs equipment.
- Up to $10,000 per year, per beneficiary may be used to pay for K-12 tuition expenses, tax free.
- Up to $10,000 (lifetime limit) for the beneficiary (and siblings) for student loan repayments, tax free.
- The beneficiary can be changed to another child or another qualified family member.
- Parental assets reduce financial aid by up to 5.64% vs. up to 20% of student owned assets.
- The owner of the account retains control and is not transferred to the beneficiary.
- Similar to a Roth IRA, contributions may be withdrawn tax and penalty free.
Disadvantages:
- Non-qualified withdrawals are subject to tax and a 10% penalty.
- Some plans have required minimum initial contributions.
- A roll-over from one state’s plan to another may subject any income tax deductions or credits to recapture.
- Limited investment options within the account, sometimes accompanied with high fees.
529 Prepaid Plan
These accounts are similar to 529 savings plans with some key distinctions. The major difference is that they are, like the name suggests, prepaid. The owner of the account will purchase tuition in the form of years, credits or units in a lump sum or installment payments.
Advantages:
- The ability to lock in tuition costs at current rates.
- Most states guarantee the funds in these accounts will keep pace with inflation.
Disadvantages:
- A prepaid plan will typically only cover tuition and fees.
- Some states have specific enrollment periods throughout the year.
Coverdell Education Savings Account (ESA)
These accounts are similar to 529 savings plans in that contributions are made with after tax dollars, money grows tax free within the account and withdrawals made for qualified education expenses are tax free. The major difference between these accounts are the contribution and income limits as well as the investment flexibility that an ESA provides.
Advantages:
- Virtually limitless investment options.
- Tax free growth and withdrawals for education expenses. Qualified withdrawals may include tuition and fees, books and materials, room and board (for students enrolled at least half-time), computers and related equipment, internet access and special needs equipment.
- The funds may be rolled over into another ESA for another eligible family member.
- Parental assets reduce financial aid by up to 5.64% vs. up to 20% of student owned assets.
- Funds may be used for K-12 education expenses.
Disadvantages:
- Contributions cannot be made after the beneficiary reaches age 18 without paying a 6% excise tax.
- Annual contribution limit of $2,000 (2021).
- The account must be fully withdrawn by the time the beneficiary reaches age 30 or the account may be subject to tax and penalties.
- You can’t contribute to an ESA if you make more than $110,000 (single) or $220,000 (married filing jointly) (2021). Phase out limits start at $95,000 and $190,000, respectively.
- Non-qualified withdrawals will be subject to tax and penalty.
Trust Funds
A trust fund is an estate planning tool that holds and manages assets on behalf of a person or organization, managed by a neutral third party. The grantor establishes the trust fund and the beneficiary is who will receive the assets. A trustee will oversee and fulfill any responsibilities outlined by the grantor as well as handle distributions to the beneficiary. A trust lets you pass assets to someone in a structured way. This allows you to set specific rules for when the beneficiary can access the assets and how they are able to utilize them.
Advantages:
- Can hold basically anything within a trust: cash, stocks, bonds, houses, businesses, artwork, etc.
- Ability to pass assets to specific people in specific ways.
- Beneficiaries do not have to pay taxes on distributions received from a trust.
- A trust can allow your family to avoid probate court. This also keeps your personal wishes private.
Disadvantages:
- Trusts can get complicated and expensive to put into place.
- Trusts reduce need-based financial aid eligibility by 20 percent of the assets value. These accounts are reported as a child’s asset when it comes time to apply for financial aid, even if access to the assets is restricted (there can be some exceptions to this rule such as court ordered restrictions).
- The assets in a trust are no longer yours. The trustee(s) will control the assets within the trust.
Home Equity Loan
Home equity is the difference between the appraised value of your home and how much you owe on the home. A home equity loan is a way to get a fixed rate loan based on this equity. Home equity loans are received as a lump sum in the amount of the loan and you can use the money for whatever you choose.
** Similar to home equity loans, home equity lines of credit (HELOC) can be used in a similar manner. HELOCs differ in that they function as a revolving line of credit. They also have variable interest rates. You will typically have 10 years to draw from the loan (draw period) and then 20 years to pay it back (repayment period).**
Advantages
- Fixed rates provide predictable payments typically with lower interest rates than other loan types.
- Repayment terms can be from 5 to 30 years.
- Home equity is not a factor in determining financial aid.
Disadvantages
- If you sell your home before the home equity loan is paid back, the remaining balance will be due.
- Home equity loans usually come with closing costs and fees that typically amount to 2-5% of the loan amount.
- A home equity loan uses your home as collateral, late or missed payments could put your home in jeopardy.
Employer Sponsored Retirement Plan (401k/403b/457b)
These types of investment plans are offered by employers to provide employees an option to save for retirement. With these plans, the employees shoulder all the risk. Some employers will offer to match employer contributions up to a specific percentage of their salaries. These accounts are funded with pre-tax dollars and are subject to tax when distributions are made.
It is important to note that there are differences between 401k’s, 403b’s and 457b’s so be sure to know the rules of your specific plan before making a savings plan.
**Some employers will offer a Roth version of these retirement account as well. Roth 401k’s, 403b’s and 457b’s all operate similar to a Roth IRA (as discussed above) in that the money is funded with post-tax dollars and distributions are tax free.**
**Health savings accounts (HSA) are tax advantaged accounts that are available to individuals who are enrolled in a qualified high deductible insurance plan. They may be employer sponsored but may also be opened on your own. Receipts saved from unreimbursed medical expenses can be used to get tax free funds from your HSA that can be used for any purpose, even years after the expenses were incurred.**
Advantages
- High annual contribution limits. For 2021 the limit is $19,500, $26,000 if 50 or older.
- Opportunity for free money if your employer provides a match.
- Tax deferred growth until the time of distribution. Contributions reduce current taxable income.
- Funds in employer sponsored plans are protected from creditors in most cases.
- Retirement account balances are not included as assets on the FAFSA. Withdrawals from a retirement account need to be reported on the FAFSA.
- Many retirement plan sponsors offer loan options on your account balance.
Disadvantages
- Early withdrawals (generally before age 59 1/2) will be subject to a 10% penalty as well as taxes.
- Often have limited investment options.
- May be accompanied by higher fees.
- Required minimum distributions at age 72.
Individual Brokerage Account
A brokerage account is a type of investment account that is often referred to as a taxable account. This is because contributions are made with after tax dollars and taxes are owed on realized gains within the account as well.
Advantages
- No contribution limits.
- Access to funds without penalty.
- Tax loss harvesting is possible (the ability to offset $3,000 of ordinary income with $3,000 of realized investment losses).
- Virtually limitless investment options.
- Parental assets reduce financial aid by up to 5.64% vs. up to 20% of student owned assets.
- No required minimum distributions.
Disadvantages
- No tax advantages.
- Brokers may charge a commission for each trade made.
Whole Life Insurance
Permanent life insurance combines a death benefit with a savings portion. A portion of the fixed premium goes towards the death benefit and another portions goes towards savings, which can earn interest and grow. These types of life insurance plans are not for a set term. Instead, they last for the lifetime of the insured so long as premiums are paid. The two main types of permanent life insurance are whole life and universal life. Others include variable life and variable universal life.
Advantages
Withdrawals up to the total amount paid in premiums can usually be made tax free.
Growth of the cash value within these accounts are generally on a tax deferred basis.
The death benefit is generally passed to the beneficiary tax free.
You are able to take loans out on the cash value of your policy. This loan does not need to be paid back but, the policy’s death benefit will be reduced accordingly. You will also pay interest on this loan.
Cash value policies will not count as assets when filling out the FAFSA.
Disadvantages
Whole life policies are expensive and often loaded with fees. These fees and salesperson commissions are often very non-transparent.
If it is the insurance aspect that interests you, a term life policy can provide a much higher death benefit at a much lower cost.
The insurance company controls how your cash value portion is invested, not you.
It takes a long time to see positive returns, making it impossible to get back the money you put in.
If you decide to cancel your policy, you will likely have to pay a surrender charge and pay tax on any earnings.
Certificates of Deposit
A Certificate of Deposit, also known as a CD, is a low-risk savings tool that is offered by banks. Share certificates are an identical tool but instead offered by credit unions. We will use CDs to refer to both of these tools going forward.
CDs are offered in fixed length terms. The most common CD terms are 3 months, 6 months, 9 months, 1 year, 2 years, 3 years, 4 years and 5 years. At the end of the fixed term is a designated withdrawal date, known as the maturity date. On the maturity date you will have access to your original investment, known as the principal, as well as any interest that has accrued over the length of the term.
Different banks and credit unions will offer different rates and terms so it can be beneficial to shop around. You may find the best rates during promotional periods, so keep an eye out for those.
Advantages:
- Fixed, predictable return in a predetermined amount of time.
- Returns without much risk. FDIC or NCUA insured up to $250,000.
- Useful to protect savings designated toward specific purchases.
- Parental assets reduce financial aid by up to 5.64% vs. up to 20% of student owned assets.
- Easy to open, comparable to opening a savings account.
- Can help reduce the urge to tap into savings to spend since you will likely incur an early withdrawal penalty.
Disadvantages:
- Do not have regular access to your money and will incur early withdrawal penalties, though you may be able to withdraw interest payments.
- Low potential return on investment.
- The initial deposit made into the CD will be the only deposit, you cannot add more, rather you would need to open a new CD.
- CDs may automatically renew for the same original term if money is not withdrawn within the grace period, usually about a week.
- Fixed rate of return even if interest rates rise during the term.
Bonds
Unlike a stock that provides ownership rights to a company, a bond is a loan from you to the issuer of the bond. Bonds can be issued by companies or governments. Bonds issued by companies are called corporate bonds, federal government issued bonds are called treasury bonds and bonds issued by non-federal governmental entities such as states, cities and counties are called municipal bonds. Bonds pay a fixed rate of return over a specific period of time. Riskier bonds tend to pay a higher interest rate while less risky bonds pay a lower interest rate.
Advantages
- Low volatility when compared with stocks.
- With fixed interest rates you know exactly what your return will be.
- Bonds issued by the U.S. Treasury and larger corporations are generally very liquid.
- Bonds are universally rated by credit agencies such as Moody’s.
Disadvantages
- The value of bonds are subject to interest rate risk. This may not be an issue if you plan to collect interest payments and hold the bond to maturity.
- Some bonds can be illiquid, such as those issued by smaller companies or bonds with a higher face value.
- Inflation can erode the buying power of fixed interest payments over time.
- Companies can default on your bonds.
High Yield Savings Account
A high yield savings account is nearly identical to a traditional savings account. As the name suggests, these accounts offer a higher APY (annual percentage yield) than a traditional savings account. These accounts are also typically offered by internet-only banks, but this may not always be the case. These accounts are FDIC or NCUA insured.
** In the same realm as high yield savings accounts are money market accounts. It is similar to a HYSA (high yield savings account) but with checking account features and typically limit withdrawals made per month. They are also FDIC or NCUA insured.**
Advantages
- Returns without much risk. FDIC or NCUA insured up to $250,000.
- Interest compounds daily.
- Parental assets reduce financial aid by up to 5.64% vs. up to 20% of student owned assets.
- Useful to protect savings designated toward specific purchases.
- Generally pretty easy to open an account (read all the details to avoid any fees).
- Easy to transfer money between accounts online.
Disadvantages
- The APY can and will fluctuate when the Federal Reserve adjusts its benchmark rate.
- It can take a few days to get access to physical cash. You will often need a local bank to withdraw cash from and wait for online transactions to process (some HYSA’s do offer ATM cards).
- Some accounts require minimum direct deposits, minimum balances and may charge fees.
- Low potential return on investment.
- You are limited to six withdrawals per month before facing fees or account closure (this could also be an advantage to help prevent you from pulling from your savings).
- There may a cap on the amount of money that will earn the higher APY and anything past that may earn a rate congruent with a traditional savings account (you could open multiple HYSA’s with different banks to side step this).
Money Market Fund
Money market funds are different than money market accounts. Money market accounts are more like savings accounts, while money market funds are a kind of mutual fund. They invest in highly liquid, low risk securities, cash, cash equivalents, CD’s, U.S. Treasuries, etc. These funds are offered by financial institutions and are regulated by the SEC. These accounts are not FDIC or NCUA insured so you could lose your principal.
Advantages
- Same day settlement, no transaction limits.
- Low risk, but not zero risk.
- Parental assets reduce financial aid by up to 5.64% vs. up to 20% of student owned assets.
- Highly liquid, can be valuable for short term savings.
- No minimum investment requirement.
- The rates will adjust with the market as opposed to a fixed rate investment.
Disadvantages
- No FDIC or NCUA insurance.
- Low potential return on investment.
- Some accounts have expensive fees.
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