This week, we’ll be diving into a much-requested topic: how to save and invest for our children’s future. This has been a very popular request, so we’ll be getting into specific detail on options.
First, you’ll need to establish some goals you’d like to reach for your child. Do you want to start a college fund, invest for a “nest egg,” save for down payment on a home/car, or a combination?
Do you also want to teach your child about finances, budgeting and best money management?
Education
If looking to strictly fund your children's college education, another option is a 529 Qualified Tuition Plan. This is a college-savings product that has tax advantages built-in, and the parents keep control of the assets.
You contribute money to the plan, and it’s invested in mutual funds (you can also choose the funds being invested in). Many of these plans also offer “target-dates,” which modifies their investments over time to be more conservative as the child gets older.
Withdrawals from a 529 Plan can be used for college expenses, tuition, fees, room/board, and other related costs.
You can only use these funds tax-free for education purposes. If you use them otherwise, you’ll be subject to federal AND state income taxes, as well as a 10% tax penalty on earnings.
The SECURE Act of 2019 recently broadened 529 withdrawals to include “apprenticeship program” tuition, and up to $10,000 in Student Loan Debt Repayment for account beneficiaries and their siblings.
There are no income limits for contributions with this option, and it can be transferred to another child or family member if the original beneficiary chooses not to attend a college or trade. Also, there are tax breaks for opening a 529 Plan in certain states.
Here are some Federal tax benefits to opening a 529 College Savings Plan:
● Contributions eligible for annual gift tax exclusion of $15,000 ($30,000 for a joint couple)
● Contributions beyond annual gift tax exclusion are eligible for 5-year gift tax averaging, permits lump sum contributions of up to $75,000 ($150,000 for a joint couple) without incurring gift taxes
● Earnings accumulate on a tax-deferred basis
● Qualified distributions for K-12 tuition and qualified higher education expenses are entirely tax-free
● The earnings portion of a non-qualified distribution is taxed at the beneficiary’s rate and is subject to a 10% federal tax penalty
Investing for Retirement
Next, we’ll look at investing for retirement. You can create a Custodial IRA for your child as either a Roth or Traditional IRA -- the difference being when you pay taxes on its contributions.
A Roth will allow your child to make tax-free withdrawals on all earnings at retirement age of 59-- but if they withdraw early, they’re subject to penalty.
A Traditional IRA gives tax deductions, which would reduce your child’s taxable income. Most kids aren’t making much income, so usually a Roth fits best -- but if they have a job with a 401(k) in the future, a traditional IRA could help reduce their taxable income.
In both variations, the child can become legal custodian of the account when they reach age 18. After that, they decide whether or not to leave these earnings in their account.
An alternative to IRAs for investing would be a Brokerage Account. They’re taxable accounts that allow you to invest in bonds, stocks, mutual funds, etc. They have few restrictions, tax advantages, and pay dividends to the investor. You’re able to transfer account ownership to your child at age 18 -- just like with an IRA.
However, be mindful about Brokerage fees charged for trading when choosing an institution.
UGMA/UTMA Accounts (Uniform Gifts to Minors/Uniform Transfers to Minors) function similar to a 529 College Savings -- but allow your child to spend the funds on anything. This option is less popular for its return on investment, but it is another option.
Wealth
If you’re looking to save and teach your child about investing at the same time, opening a Custodial Account would be beneficial. Your child would be the legal holder and beneficiary of the account, you’re just opening it for them. You could choose to invest in individual stocks and securities together, and it’d be a shared learning experience.
The bonus with a Custodial Account is that its earnings are taxed at the child’s rate, not yours!
The tax rate on the first $1,100 may be as low as 0% – however, unearned income that exceeds $2,200 may be subject to tax using estate/trust brackets.
Something to keep in mind: these count as assets, so they may reduce a student’s financial aid eligibility when applying for college. It also may reduce their ability to access other forms of Federal aid.
An HSA (Health Savings Account) is a smart way to cover your family’s medical costs with great tax benefits, as HSA contributions and earnings are not taxable.
Credit Building is another method of giving your kids a financial advantage -- either in the form of a secured credit card, or as an authorized user on one of your accounts. That will give them opportunities in early adulthood (renting an apartment, loan worthiness) that others miss when coming in with zero.
Life Insurance is another popular method to build family wealth.
If you select a permanent insurance policy, you can take out a loan against its accumulated Cash Value for things like supplemental retirement/college funding, starting-up a business, etc. This boosts your own investment portfolio, as well.
If you select a term insurance policy, the policyholder receives all premiums paid right back to them if they outlive the term. They’re protected through the term, and get their money right back. It’s like a savings account, that offers protection for the unexpected.
Lastly, your child can be a “trust-fund baby” if you create a trust in combination with your life insurance policy. Trusts require a lawyer and work in defining its terms, but have strength in fully dictating how you want your assets to be disbursed to your beneficiaries.
You can establish the trust as beneficiary of your Life Insurance policy, and then establish your child as the beneficiary of the trust. In the circumstance that your policy pays out, your assets will be protected and your lineage will be financially secure.
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