What investment vehicle should you use to save for your child’s future?
In this article, we’ll break down the pros and cons of 3 of the most common accounts: Custodial Brokerage Accounts, 529 College Savings Plans, and Trusts.
Making the decision to save for your child’s future can impact them significantly as they grow into their adult lives. It also comes with many decisions to make. Some of the top considerations that come to mind for many parents are:
- “What type of account(s) should I open?”
- “What is the tax efficiency of the account(s)?”
- “When and how my child will access these funds?”
Custodial Brokerage Account
A custodial (UTMA/UGMA) brokerage account is an account that, on its face, operates like a traditional brokerage account. They are typically free or low-cost and allow you the ability to buy stocks, bonds, mutual funds, ETFs, and more. At any time, you can take cash out of the account as long as it is for the benefit of the minor. This means you cannot dip into the account if you need or want to use the funds for something else. Eventually, the account will convert to an individual brokerage account in the name of your child. Depending on the state, this can happen anywhere between the ages of 18 and 25.
The drawbacks of a custodial brokerage start with how they are taxed. Any cash you put into them is not tax deductible and all earnings are subject to tax. More specifically, custodial brokerage accounts are subject to something called the “Kiddie Tax”. The Kiddie Tax breaks down like this:
- The first $1,100 of gains from dividends, interest, or capital gains in the account are tax-free
- The next $1,100 are subject to the child’s tax rate
- Anything over $2,200 is taxed in the tax brackets associated with Trusts and Estates.
If you have ever taken a peek at what the trust and estate brackets look like, you’ll know that you can reach the top tax bracket a whole lot faster than your normal tax bracket. Additionally, losing access to the account when it converts to an individual account in your child’s name can pose its own set of problems.
For example, I had a client who had bought a particular tech stock in their child’s custodial account when they were first born. Their initial investment of $10,000 had grown to well over a million dollars. The child had behavioral issues and distanced himself from the family. His 21st birthday was coming up and the mother knew she would lose control of this custodial account as it was set to convert into an individual account in the child’s name. Despite her efforts, legally there was nothing the mother could do to stop her estranged son from now gaining unrestricted access to this multimillion-dollar account as the gifts/contributions she made to it are considered irrevocable. This is a more extreme example but if you have concerns about your child gaining unrestricted access to a potentially large sum of money, a custodial account may not be the best choice.
529 College Savings Plan
A 529 college savings plan is another low-cost way for you to save for a child’s higher education costs in a tax-advantaged manner. 529 accounts are incredibly popular because assets grow tax-free, and come out tax-free, provided you are using them for qualified expenses like tuition costs, room & board, and books. As of 2018, up to $10,000 of a child’s 529 can be used to cover K-12 enrollment or tuition.
A drawback of using a 529 is if your child doesn’t go to college. If you don’t use the funds in a 529 for qualified education expenses, you will pay ordinary income tax on any earnings PLUS a 10% penalty (your principal investment is not taxable). If you are in a situation where your child doesn’t go to college, you can potentially move the 529 funds to another child’s tax ID or you can just bite the bullet on taxes and incur the penalty when the funds are withdrawn. The years of tax-free growth can potentially help ease any tax hit associated with a non-qualified distribution. Another weakness of a 529 account is the lack of investment choices. A 529 has a limited investment menu, similar to a 401k. This means there is little you can do if you want to buy an individual stock or use alternative asset classes/choices.
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Establishing a trust for your child will give you the most customization and control in terms of when and how your child can access the funds. For example, a trust may have language around:
- Setting distribution schedules on the cash in the trust based on life events, age, etc.
- How long the child gets access to the funds once it is accessible.
- Covering all children in the household. Trusts can be more generic and not be made just for a single child.
- Who the trustee of the trust is. You can be in charge of administering or distributing it or you can use a professional trustee.
These kinds of trusts generally carry more creditor protection as well. The downsides of establishing a trust for your child are higher administrative expenses and potential tax implications. You will need to hire an attorney who can draft and establish the terms and documents associated with the trust. You will also have annual tax reporting for the trust and need to be mindful of the taxation of the investments within the trust, due to a more compressed tax bracket. For families with sizable wealth or assets that they would like to give to their children; or with families needing more safeguards in place, the customization and control of a trust can far outweigh the administrative costs and tax implications that they may present.
Bonus: Custodial Roth IRA
If you are looking for a way to get a head start on your child’s retirement savings, a custodial Roth IRA can be a great option. The custodial Roth works like a custodial brokerage account where you will need to set it up for your child and they gain access to it later. However, they receive all the tax-free growth and benefits associated with a Roth IRA.
To be eligible, your child needs to have earned income from working. That means they earned this income at a job (lemonade stand, babysitting, etc.) AND they paid taxes on it. They will also be limited to how much they can put in based on standard contribution limits, or the earned income they have, whichever is lower.
What Should You Do?
As in all cases, your personal financial plan will dictate which account(s) to open. Depending on your family’s needs, it may make sense to use a combination of some or all the accounts covered in this article to optimize savings. If you are looking to create an optimized savings strategy for your children, reach out to our financial advisors to optimize your financial plan.