The best place to save for your children depends on the goals you have for your savings. Do you want to save for their future education, their retirement, big expenses like buying a home or a wedding, or something else?
Each of these goals has a different strategy, as discussed below. If you have several goals in mind, one important thing to consider is that you do not have to pick one single option and can utilize a combination of planning strategies.
We like to compare saving for your children to an oxygen mask when you are on an airplane. It is important to save for yourself first. Your children can always take out loans for school or save for themselves, but you cannot take out loans to fund your retirement later on.
Education
There are a few tax-advantaged ways to save for your child’s education. The most popular option is a 529 plan, which allows tax-deferred savings to be invested and used tax-free toward qualified education expenses (including K-12 tuition, college tuition, room and board, books, laptops, etc.). Some states even allow a state income tax deduction for contributions to their 529 plan.
Anyone can open a 529 for a beneficiary, including family friends or grandparents. For parents wanting to save for a child before they arrive, they can even open an account naming themselves as beneficiary and then update that to name their child later. If a 529 is not needed, the account beneficiary can be renamed to a qualified beneficiary. When picking where to establish a 529 plan, it is important to consider your home state’s tax advantages and the investment options (and their costs) available within the plan.
There are a few downsides to saving to a 529 plan. Tax-free withdrawals are subject to qualified withdrawal rules, which do not include travel expenses, extracurricular activities, or health insurance. Also, for those who are taking advantage of the American Opportunity Tax Credit, you cannot “double dip” to take the tax deduction for expenses paid from a 529. Finally, if you have unused 529 funds (received scholarship, did not attend college, etc.), and you need to withdraw the savings, the earnings portion of your non-qualified withdrawal would be taxed as income, along with a potential 10% penalty (depending on your situation).
Because of the limitations of the 529 plan, some parents find that they prefer to save for college within a brokerage account, whether it be their own or a custodial account. While brokerage assets are not tax-advantaged, they are accessible at any time, and are not penalized if not used for qualified education. The downside to using brokerage assets as a savings vehicle for education is that when it comes time to file a FAFSA and qualify for financial aid, a higher proportion of the assets are included as available for education spending.
Personal Goals
For more personal goals (including future cars, weddings, and home down payments), you may want to consider a custodial account. Custodial accounts, such as UTMAs and UGMAs, allow you to act as custodian of a brokerage account/after-tax assets for a minor child. The difference between UTMAs and UGMAs lies in what investments are available – UGMAs can hold traditional investments (cash, stocks, bonds), and UTMAs can hold traditional investments along with real estate.
Both accounts are easily accessible to investors and provide a lot of investment flexibility because there are no qualifying rules for contributions or withdrawals like there are on other accounts. Accounts can be opened at banks (similar to a savings account), but brokerage institutions, such as Schwab, Fidelity, or Vanguard, may allow you to grow savings for longer-term goals.
Check out the video below for our thoughts on how to make your children multi-millionaires!
