By: Paul Horn, CFP®, CPWA®, Senior Financial Planner
As parents we always want to see our kids succeed and do better than we did. This means many times we want to invest in their future for various things. Most of the time parents want to save for education, but there could be other reasons to save. For example, helping them buy their first home, seed money to start their business venture, or to pay for a wedding. Below are the most common account types and when it may be the best choice based on your goals for the money. Some may notice that the Coverdell (Educational IRA) is not listed and that is because it is no longer relevant given recent changes to the 529 Plan.
529 Plan: Best account for saving for education
- Best used if you 100% know that the beneficiary is going to use the funds for college, post-secondary education, or private school.
- For 2022, the max that can be contributed in one year is $16,000 per person per beneficiary (or $32,000 with gift splitting). There is also an option to superfund a 529 where 5 years of contributions are made in one year.
- Contributions grow tax-free and distributions can be tax-free as long as they are used for qualified education expenses. Qualified education expenses include (but are not limited to) items like room and board, tuition, and books.
- Contributions can be deductible at the state level depending on your state.
- If the distribution is not for qualified education expenses, the earnings on the distribution are subjected to ordinary income taxes and a 10% withdrawal penalty.
- You can switch the beneficiary at any time. Let’s assume you have money left over after the oldest child graduates; you can transfer this money to the next kid in college.
UTMA/UGMA (custodial account): Best account if you want your kid to have the money at 18 or 21 without any limitations
- In 2022, this is an account where the custodian can contribute $16,000 per year to an investment account for a minor child. At the age or majority (usually age 18 but can be increased to age 21 or 25 in some circumstances), the minor child then becomes the owner of the account.
- While the minor child is still listed on the UTMA (Uniform Transfer to Minors Act) account or UGMA (Uniform Gift to Minors Act) account, the earnings are subject to capital gains at the following schedule:
- The first $1,100 of unearned income is free from tax,
- The next $1,100 is taxed at the minor’s tax rate,
- Earnings above $2,200 are taxed at the parent’s tax rate.
- When the account transfers to the minor child due to the minor child reaching the age of majority, earnings and distributions are taxed at capital gains tax rates.
2. Put money into a taxable account in your name – Best option for anything not education specific
- There are no limits on how much you put into the account or how the money is used.
- You maintain full control of the assets and determine when and how much they receive.
- This is a taxable account, so it would be subject to regular taxes (i.e., interest income, capital gains, dividends, etc.)
- If your kid(s) were to inherit the taxable account, the securities in the taxable account get a step up in basis to virtually eliminate any tax implications for them.
- A taxable account has less impact on financial aid for your kid(s) than a UTMA/UGMA.
- Money can be invested however you choose.
- When you give the money to them it is considered a gift and limited to $16,000 per person or $32,000 for a married couple per year (2022). Any amount over this is reported on a gift tax return (no taxes are paid but it reduces your estate tax exemption).
- If the money is used to pay tuition for a school directly or directly to medical bills, then the $16,000 limit does not apply.
Roth IRA: Best if saving for their retirement
- Contributions to a Roth IRA can be made for a minor child as long as the minor child has earned income from working.
- For 2022, contributions are limited to $6,000 or the amount of earned income (whichever is lower). Assume they make $3,000 from a summer job, then you are limited to contributing $3,000.
- A parent can put money into the Roth IRA for the kids to allow the kids to keep their income they earned.
- Contributions grow tax-free and distributions can be tax-free if the owner (the minor child) is at least age 59.5 and the contributions have been in the account for at least 5 years. If not, earnings on the distributions are subject to ordinary income tax and subject to a 10% early withdrawal penalty. There are some instances where the 10% early withdrawal penalty can be waived that include (but are not limited to): buying your first home (up to $10k), college tuition, or permanent disability.
As you can see, there are many options available to you and the best account depends on what your goals are. You can reach us at email@example.com if you would like to have a complimentary call to discuss your specific situation.
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