Using Bucket Strategies to Save Money for Kids
I usually breakdown savings for kids into four categories:
- Education – The main goal being college savings
- Other less defined goals – Maybe college, maybe trade school, house down payment, or funding a future business of theirs
- I’m not sure if I want to give my kids money or not, we’ll see how they turn out – Despite our best intentions we can still have kids who may not make the best choices in which case you may not feel comfortable giving them money
- Help with Retirement – You would like the money to be invested for the long-term in a retirement account to give them a headstart
As you can see, these categories are more goals-based with a little gut check thrown in for good measure on how you think they’ll turn out. The reality is that there is uncertainty and you need to feel comfortable with the decisions you are making now.
Gifting & Money Saving Accounts for Minors
The categories listed above will help dictate the types of accounts you will want to use for your kids. I will go through each type of account and explain its pros and cons.
The two main types of accounts are UTMA/UGMA custodial accounts and 529 college savings plans. These are good tools to use when receiving money as gifts from grandparents or other family members.
Keep in mind, as of 2021 the annual gift tax exclusion is $15,000 per person. This means you should keep your gifts below this number or else you will have to file a gift tax return which could negatively impact your estate tax situation in the future.
Custodial Accounts – UTMA/UGMA
UTMA/UGMA accounts are custodial accounts meaning that an adult will be the custodian and the child will be the owner/beneficiary. Contributions to the account are considered irrevocable gifts. They are essentially the child’s funds and for their benefit.
The custodian is responsible for managing the money until the child becomes the age of majority. This is usually age 18 or 21 depending on the state you live in. Some states allow the custodian to extend the age of the majority to 25.
This is usually looked at as the biggest drawback. A lot of people may not feel comfortable handing over a big pile of money to an 18 or 21-year-old, regardless of how responsible they may be. The custodian where the account is held will send out notices to the beneficiary when they are approaching the age of majority at which point they will convert the account into the child’s name and take control.
Custodial accounts may seem a little scary but they can be used as tools to help educate children on the importance of saving and investing. They could be used as an opportunity for the child to get real-world exposure to saving and investing money to see the importance and value of it. It may instill a sense of ownership and responsibility once the money is handed over to them. You can speak to the goals for the money and its intended use in hopes that they honor it and don’t go buy a Corvette at graduation.
Custodial Roth IRA or Traditional IRA
In the same vein as the custodial accounts, you can open a custodial Roth IRA or Traditional IRA for children. These function the same as a custodial account where the account is put into the child’s name at the age of majority. The main caveat is that the child must have earned income in order to contribute to the account. If they’re doing legitimate work, such as helping the family business or making money cutting lawns, this can be used to contribute to an IRA.
This can be a great way to encourage the child to save more retirement and get started early. They are subject to the same contribution limits which are $6,000 per year being under age 50. You can only contribute up to your earned income though. A Roth IRA usually makes sense because the funds will grow tax-free and be distributed tax-free. It’s also highly likely that the child will be in a higher tax bracket during retirement.
As long as the child has earned income they will have the ability to contribute to IRAs. Parents can also gift funds to their IRAs if they would like.
I’ve spoken about a 529 plan here if you’d like to see the limits for the account. The main point I want to get across in this article is that this is the bucket you want to use specifically for college. This is because the funds grow tax-free and can be removed tax-free for qualified education expenses. These expenses can be seen here. You now have the ability to use the funds for K-12, but this is too short of a time horizon in my opinion to consider investing the funds. You would likely be better off paying for private school out of income.
These are state-run plans but you do not have to use your own state’s plan. The main things to consider when choosing a plan are the ease of use, fees, costs of investments and administration, investment options, and if your state offers a deduction for your state income taxes.
If there is any doubt about your child going to school, I would recommend setting aside money in a taxable investment account earmarked for them at a later date or using a custodial account. One way you can hedge against this risk is that you do have the ability to change the beneficiary to another family member. You can change the beneficiary to another child, niece or nephew, you, or your spouse if they want to go back to school. This seems to provide some comfort for people.
The penalty for withdrawing the 529 funds for non-qualified expenses is that you will include the earnings as income and incur a 10% penalty. This could be almost 50% depending on your income tax bracket.
ESA – Education Savings Accounts
A Coverdell ESA account or education savings account can be used for college and K-12 expenses as well. You must distribute the account or roll it over to another beneficiary once the child turns 30. You also can only contribute up to $2,000 per year for the child.
This makes the account more restrictive in being able to build up substantial assets. You do have more flexible investment options since most platforms like Fidelity or Schwab will allow you full access to their investments.
Ear Marking Taxable Investments for a Child
Another strategy is to save money in a taxable account in your name for children. For example, this can be done in a separate account or earmarked in a mutual fund inside your brokerage account. This way the funds stay in your name and you have full control over them.
There aren’t any issues around tax penalties or the children receiving the money too soon as with some of the other accounts. This way you can gift money to your children when the time is right. If you do this in a joint account with a spouse you can each gift up to $15,000 per year for a total of $30,000 if you want to expedite the process.
I hope this has been helpful. I always recommend starting with asking yourself what is the purpose of the money and then dive further into the details from there. We can’t predict the future but we can mitigate risk and prepare for our children’s future by planning accordingly.
If you’d like an objective second opinion about your finances, please contact Michael Shea, a CERTIFIED FINANCIAL PLANNER™, at Applied Capital. Email him at [email protected] or fill out a contact form.
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