Updated: Jul 7, 2020
From basketball camps to SAT prep classes to prom dresses to college tuition - kids are expensive.
Fortunately, there are several savings and investment tools available to help parents put money aside that will financially aid their child's future. While a handful of investment tools exist, we will only discuss three of the most common: UGMA/UTMA Accounts, the 529 Plan, and The Custodial Roth IRA.
Uniform Gifts to Minors Act/Uniform Transfers to Minors Act (UGMA/UTMA) Accounts are investment accounts you can set up for your children or a minor. Both accounts allow investors to invest in stocks, bonds, and other traditional securities. The UTMA Account, however, also allows you to invest in real estate and other hard assets. Here a few other rules you should know about these accounts:
An adult over 21 must be named a custodian of the account.
The beneficiary must be a child under 21.
The custodian is responsible for any withdrawals, investments, etc. until the beneficiary turns 21 (this age can vary by account and by state).
UGMA and UTMA accounts allow for flexibility with investments and distributions. Unlike the 529 plan, withdrawals will not be penalized if not used for education (although distributions cannot be made for parental obligations). Music lessons, dance camps, field trips across the country and other expenses that will benefit the child can be paid for with these investment accounts.
These types of investment accounts are not always the most tax or financial aid friendly. Earnings over a certain amount will be taxed either at the kiddie tax rate or, if the child files their own tax return, earnings will be taxed at the child's income tax rate. Also, assets in these accounts are considered "assets owned by student" and can count for as much as 20% of the expected family contribution on the free application for federal student aid.
The 529 Plan
A 529 plan is an education savings plan. This plan is set up as an investment account from which you can only withdraw funds to be used for qualified education expenses such as tuition, books, etc. All distributions made for qualified education expenses can be withdrawn tax-free. Funding this plan can also have tax advantages because more than forty states (unfortunately, California is not a participating state) offer a an income tax benefit for 529 plan contributions. Not only that, when applying for college financial aid, 529 plans are considered assets "owned by the parent" which account for less than 6% of the federal expected family contribution.
Please note, certain colleges and universities can count 529 plan assets towards an expected family contribution that is higher than 6%. Consult your college and university before submitting financial data.
The Custodial Roth IRA
Some parents set up a Roth Individual Retirement Account (IRA) to manage for their child until their child turns 18. This type of account is called a Custodial Roth IRA. Although this is a retirement account, only investment earnings will incur a penalty if withdrawn before retirement age. Contributions, however, can be withdrawn at any time.
So, if you funded the account with $1,000 and earned $100 in interest income on that account, the $1,000 could be withdrawn at any time. The $100 of interest would have to remain in the account until your child reaches the qualified retirement age.
The Custodial Roth IRA can be funded once your child has earned income. One way to do this is create an LLC, give your child age-appropriate jobs for the LLC (address envelopes, scan papers, etc.), pay them, and use that earned income to fund the Roth IRA.
Contributions into a minor's investment account could be considered "taxable gifts". According to the IRS,
"you make a gift if you give property (including money), or the use of or income from property, without expecting to receive something of at least equal value in return. If you sell something at less than its full value or if you make an interest-free or reduced-interest loan, you may be making a gift."
In 2019, gifts over $15,000 will be deducted from the $11.4 million estate tax exclusion amount and are thus considered "taxable gifts". You will want to discuss any amounts you plan to contribute into your child's investment account with a CPA to determine whether or not the gift tax is applicable.
It is important to consider all options when saving for your child's future. For example, if your child is on a path to receive a full athletic scholarship to college, you might want to put more money into a UGMA/UTMA Account, Custodial Roth IRA, or other investment account that is not limited to qualified education expenses since most of those will be paid for by the college. Or, perhaps you will continue to put all funds into the 529 plan and just designate a different beneficiary. Whatever you decide, when you consider all of your options, you can ensure the money you save will make the maximum impact on your family's financial future.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisers before engaging in any transaction.