The best place to save depends on the goals you have for your savings.
Before making any decisions about your future plan, it may be worth sitting down to think about what you envision for your kids – pre-paid education, a house/car down payment, retirement savings, disability needs funding, etc.
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 (Check out the Financial Order of Operations). 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. Just remember, you are actually doing them a favor this way because you will not end up living in their basement one day.
There are a few tax-advantaged ways to save for your child’s education. The most popular option today is a 529 plan, which allows tax-deferred savings to be invested and used tax-free toward qualified education expenses (i.e., K-12 tuition, college tuition, room & 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 (received scholarship, did not attend college, etc.), 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 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.
Video: The Best Ways to Save and Pay For College
For more personal goals (future cars, weddings, home down payments, etc.), 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, etc.), 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.
There are a couple things to think about when investing a custodial account. First, the account legally becomes the child’s asset once they hit the “age of majority”, usually 18 or 21 (state-specific law). Second, if income is high within the account, it could be subject to Kiddie Taxes, which are higher than standard tax rates.
It is no secret that The Money Guy team LOVES Roth assets, so we love the use of Custodial Roth IRAs when possible. Contributions are taxed before they are invested, but continue to grow tax-free until retirement. Having the opportunity to take advantage of so much tax-free, compounding growth can be a game-changer for your children. If you think 88x over is impressive, check out this resource that shows the power of compounding growth for kids. One strategy Brian likes to use to incentivize saving is a dollar-for-dollar match with his daughter. For every dollar his daughter saves, Brian also invests a dollar (up to the eligibility limit).
To qualify for Custodial Roth IRA contributions, children must have taxable, earned income. For example, an earned paycheck from working as a lifeguard would count, but non-taxed cash earned from chores would not.
Keep in mind that Roth IRAs are intended for long-term saving and investing. If you are saving for a specific need pre-retirement, you may want to revisit your options to ensure you will have full access to your savings.
If your family needs require saving for a child’s disability, you may want to investigate an ABLE account. ABLE accounts are intended for the Maintenance, Health, Education & Support of those with disabilities. If eligible, an individual can have one account (tied to their SSN) opened through a state. Contributions are limited to $15,000 annually from outside sources, but can grow tax-free if used for their intended purpose. A beneficiary with earned income can save their earned income to the account, as well.
If someone eligible for the ABLE was the beneficiary of a 529 account (intended for education expenses), and that account is no longer advantageous, 529 assets can be rolled into the ABLE. Also, ABLE accounts do not disqualify beneficiaries from governmental programs such as Medicaid and SSI. To qualify, a person must be diagnosed with a disability before age 26.
Check out Brian & Bo’s thoughts!
Video: How to Be Young Money Millionaires! (By Age)