What is the best way to save money for children?
I get this question quite a bit from new and existing clients alike. It usually gets brought up by parents, but sometimes it comes from aunts, uncles, grandparents and other guardians.
The answer, as it is to so many financial questions, is: It depends on the financial goals and wishes of the saver.
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While it can be hard to determine what a newborn will be interested in at age 18, opening pathways with a nest egg is a good start. Some of the most common account types to save for children:
Each have a different set of benefits, depending on your priorities.
529 plans
529s are tax-advantaged savings vehicles for guardians to save for higher education. Depending on where you live, your state might offer a specific tax benefit for savings efforts.
Some states offer a tax benefit for both in-state 529 plans and plans from other states so you’ll need to confirm what regulations apply to you.
Similarly, some states also recapture the benefit if the money is used for noneducation purposes. As you’re considering what choice to make, one important piece of the puzzle is confirming your state tax benefits with 529 plans.
With rising higher education costs, 529 plans are becoming more impactful. The passage of the Secure Act 2.0 expanded options for those funds by allowing the rollover of funds to a Roth IRA and a change in beneficiary.
Roth IRA rollover
After an account has been open for 15 years, money within a 529 can be repurposed as Roth contributions, as long as the funds are at least five years old.
For example, if you have $10,000 in a 529 and contributed another $5,000 during year 15, that deposit must remain in the 529 account for five years before it can be moved to a Roth IRA. The initial $10,000 can be transferred during year 15.
While a minor can’t sign Roth IRA account paperwork, adults can open a custodial or guardian Roth on their behalf.
I also often hear clients say, “I want to open a Roth IRA for my child.” If the minor has a W-2 for wages earned, you can.
I once worked with a grandmother who opened one for a granddaughter who had a minimum wage summer job as a pool lifeguard. Once a year, the two would come in to contribute the amount in the granddaughter’s W-2 to a Roth, typically a few thousand dollars.
While the granddaughter spent the money she earned on other things, her grandmother would gift her an equal amount in her Roth contribution. At 18, the grandchild was able to re-register the account in her own name.
Nonqualified distributions
While a 529 account is ideally used for education expenses, nonqualified distributions might also be an option for noneducational uses for 529 funds.
Even if used for other purposes, principal contributions can be withdrawn without tax or penalty, although earnings are charged a 10% penalty to the IRS.
If the account is started for a newborn and the nonqualified withdrawal is completed on or by their 18th birthday, the owner can still enjoy 18 years of state tax benefits and tax-deferred growth.
I sometimes get savers who put their personal experiences first when making decisions for their children’s savings. I’ve heard many times, “I did not have a 529 to pay for higher education, and I made it work.”
Other times, the saver might be concerned that a 529 could influence a child’s decision to pursue higher education.
In those cases, Uniform Transfers to Minors (UTMA) and Uniform Gifts to Minors Act (UGMA) custodial accounts might be better alternatives.
UTMA and UGMA accounts
As an alternative, these types of accounts let you save for a child without the expectation that the funds will be used for education.
Instead, deposits are an irrevocable gift to the child, and the adult custodian manages investments until the child reaches the age of maturity.
Coverdell Education Savings Account (ESA)
One of the final ways to save for a child’s education is with a Coverdell ESA. During my 15-plus years in the industry, I’ve seen few of these.
In my opinion, 529 accounts are often preferable, given their flexibility. ESAs have low contribution limits, and the assets must be used by age 30.
High-income earners are also ineligible for these accounts and others can only contribute to the account until the child’s 18th birthday.
So many choices — what should you do?
I have children and reviewed the same options for my family. For our circumstances, I found the best options to be an UTMA and 529.
The benefits of the 529 shine the most in my opinion, and I have automatic monthly contributions to a 529 for each of my children. As they become comfortable making their own financial decisions, I’m onboard with Roth contributions for unused 529 assets or even cashing out the accounts to give the cash to my children.
I can even transfer an unused 529 for one child to another, without tax or penalty while replacing the funds with personal savings.
For the UTMA account, I deposit any gifts of cash my children receive for holidays or birthdays. To encourage good financial values, I let them decide how much to save.
For those trying to pick the best option for their family, whichever path you choose, you’re working toward a goal. We don’t know what the future holds, but rest assured you helped your loved one in some way with your savings efforts.
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