How to Save Money for Your Kids

Most parents want to give their kids the best financial start.  However, I’m sure parents are a little flummoxed when it comes to exploring the options and deciding what the best options are.

In this blog, I will be reviewing the pros and cons of six of the best savings options for your kids, so you can hopefully figure out which one is the right fit for your family.

• 529 college savings plan
• 529 prepaid tuition plan
• Roth IRA
• UGMA/UTMA account
• Brokerage account
• Savings account

1. 529 COLLEGE SAVINGS PLAN

If you know that college is an option for your child in the future, then paying for college or university tuition is the most common reason that parents want to save money for their kids.  One of your best options is a 529 college savings plan.

With a 529 plan, you make contributions and invest them in an array of options, such as mutual funds. Your money can be withdrawn tax-free when it’s used for qualified education expenses, such as tuition, fees, books, required equipment, as well as boarding.

Funds in a 529 plan can be used at any accredited school in the country, and even at some foreign institutions.  So, an example is, you could live in New York, participate in a Florida 529 saving plan, and use the money to pay for a school in California.  As you can see, it’s flexible and works for you.

As a bonus, you can spend up to $10,000 per year tax-free on elementary and secondary school expenses, according to the Tax Cuts and Jobs Act. That gives parents the flexibility to make withdrawals for tuition and other educational expenses for a younger child who attends a public, private, or religious school.

As there’s no restriction on annual income, everyone can use a 529 savings plan.  The maximum amount you can contribute each year varies on the chosen plan but could be over six figures per student!

The funds in a 529 plan belong to the owner and the account can have one designated beneficiary, that being the future student.  If wanting to save for more than one child, then you must open an account for each child.  You have the flexibility to change a 529 beneficiary to another member of the family or roll it over to another 529 plan without the tax implications.

Contact your financial advisor to sign up for a 529 – it does not matter if you contribute $10 or a $1000 a month – the aim is to sign up sooner and ensure that you’re able to pay for college tuition.

Pro: Due to all the benefits that come with a 529 plan, such as tax advantages, flexibility, and high contribution limits, this is a great account to save for education costs. Additionally, distributions receive favorable treatment as they're not factored as income in the calculation for the following year's financial aid eligibility.

Con: The main drawback is that using 529 funds for anything other than qualified education expenses, triggers income tax, plus potentially a 10% penalty.  So never contribute more to a 529 than you believe your child will need for the total of their education expenses.  Also, you can’t begin investing until your child is born and has a Social Security number.

2. 529 PREPAID TUITION PLAN

If the idea of setting aside money for your children’s education appeals to you, but you don’t want any investment risks, then think about the 529 prepaid tuition plan. These plans are offered by states or institutions but aren’t available in every state. The idea is that college costs rise year after year, so locking in future tuition at today’s rate can save money.

But what if your child wants to go to a different school? Funds in a prepaid plan may be withdrawn so you can use them at an out-of-state school or at a private college. You can also change plan beneficiaries at any time if you have another potential student in the family.

You can even have both a 529 prepaid plan and a 529 college savings plan for the same beneficiary. The prepaid account would pay for tuition and the savings plan could be for other expenses, such as boarding, books, stationery, and computer equipment.

3. ROTH IRA

In my opinion, the Roth IRA (Individual Retirement Arrangement) is a great investment tool because it’s one of the best places to invest for the long-term. Not only does it give you tax-free money in retirement, but unlike other types of retirement accounts, you can spend it before retirement without having to pay taxes or an early withdrawal penalty if you do so according the specific IRS rules on withdrawals.

Contributions to a Roth IRA are not tax deductible, but you can invest them in a broad array of options, and withdrawals in retirement are completely tax free.  Additionally, since you pay tax upfront, you can withdraw original contributions at any time and for any reason, including a child’s education after the Roth IRA has been open for at least 5 years.

The great thing is, many people don’t realize that kids can have an IRA.  Parents can give their child a
financial head start by opening a Roth IRA in the child’s name.  An important fact to note is that a retirement account can never be owned jointly or owned for someone else.
 
For a minor to qualify for an IRA, they must have their own earned income. In other words, children only qualify to have an IRA if they have a part-time job or self-employment income. As a parent, you can make an IRA contribution on a child’s behalf, if the child’s income is legitimate.  If a child earned money during the tax year, either you or your child can contribute as much as they earned, up to the annual limit, which is currently $6,000 in 2019.  Please keep in mind that you can’t fund an IRA for an infant or a toddler who can’t legitimately earn income. So, it’s generally just an option for teenage kids.

If you have a very young child or a non-working child, another option is to fund your own Roth IRA and then take withdrawals from it later to pay for college expenses. There is an annual income limit to qualify for a Roth IRA, so if you’re a high-earner you may be prohibited from contributing to one.

If you’re not sure how to open a Roth IRA, get in touch with your financial advisor.

Pro: A Roth IRA offers flexible withdrawals of original contributions for college expenses, down payment on a home, or even for a business expansion. And unlike with a 529 plan, if you don’t end up needing some or all the money for college, you can simply leave it in a Roth IRA and use it for another reason or for retirement. Whether you or your child own the account, the balance is not counted in the calculation for financial aid.

Con: If you withdraw earnings in the account prior to age 59½, they may be subject to tax and penalties if the purpose is not an allowable exclusion. Also, withdrawals of contributions and earnings do count as income on the following year’s financial aid eligibility.

4. UGMA/UTMA ACCOUNT

What if you want to invest money for a child’s future, but don’t want the funds to be used only for education? In most states, minors can’t own investments and financial products in their own names. Meaning, parents can’t just give an investment or transfer an asset to a minor child without creating a trust.

The most common trust for minors is a custodial account known as a UGMA (Uniform Gift to Minors Act) or UTMA (Uniform Transfer to Minors Act). These were created as simple ways to hold investments, real estate, and other assets for minors, in the care of an account guardian.

You can set up a custodial account at most banks and brokerage firms. You can make withdrawals to cover expenses that benefit the child, and when the child becomes an adult (usually at 18 or 21, depending on your state), the assets automatically transfer into his or her name.

Pro: You can give a child as much money or assets as you like with no annual limits and you can also withdraw funds at any time and for any reason. A portion of investment earnings are taxed at your child’s income tax rate, which can cut taxes.

Con: The downside of UGMA and UTMA accounts is that once the child reaches the age of majority, parents have no control over how the child spends it. Also, custodial accounts are considered an asset of the child, which means they’re a larger factor in the financial aid calculation than if they were owned by a parent.

5. BROKERAGE ACCOUNT

If you’re not sure whether money you save for a child will be used exclusively for education and you’re not eligible for a Roth IRA, another option is to invest through a taxable brokerage account. Speak to your financial advisor as to which option is best suited to you as one can choose from a wide variety of investments and make withdrawals at any time and for any reason, such as your child’s education, a car, or a wedding.

Pro: A brokerage account gives you maximum flexibility and the potential for growth over the long term.

Con: You’ll owe income tax on your investment gains or losses each year in a brokerage account. Plus, the value must be included in the calculation for financial aid.

6. SAVINGS ACCOUNT

An FDIC-insured bank savings account is one of the safest places you can invest money for a child’s future.  The main problem is, it doesn’t come with many benefits. For example, you get very low interest rates, and what you do earn is taxed as income.
 
If you open a savings account in a child’s name or your own name, also consider using another account that offers more aggressive growth, such as a 529 plan, a Roth IRA, or a regular investing account.  These options assist you in beating the average rate of inflation over the long-term, which has been about 3%.  If you’re not earning more than 3%, what you set aside for your child’s future will lose value over time.

Let’s look at this example: If you save $100 a month for 20 years in a bank savings account that earns 0.25% interest, then you’d accumulate less than $25,000.  But if you put the same amount in an investment earning an average of 7%, you’d have over $52,000 after two decades.

Pro: An advantage of a bank savings account is complete safety from investment risk.  It also has a non-financial benefit in that it helps familiarize your child with the concept of saving money, which has so many benefits!

Con: The main con is that using only a low-rate savings for your child’s future could cost many thousands in missed investment growth. Plus, the value must be included in the calculation for financial aid.

A word of caution here: Don’t sacrifice saving for your own retirement to pay for college. Instead, speak to your financial advisor to create a financial plan that includes both college and retirement savings as soon as you start a family.

Bottom line is, the sooner you start saving the less stress you’ll feel both psychologically and on your budget.  If you happen to get a late start and can’t afford to pay for a child’s education, don’t feel guilty.  Remember that putting retirement first is in your entire family’s best interest.

If you have ever flown on a plane you probably will recall the safety announcement about making sure to put on your own oxygen mask before helping those next to you.  In other words you can’t be much good to anyone else if you haven’t taken care of yourself first!

If you sacrifice your own financial security for your kids’ college, you may find yourself relying on them to support you in your old age!  While this may seem somewhat heartless for a parent to refuse to pay for a child’s education, don’t forget that kids have options, such as:

• Attending an inexpensive state school or community college
• Applying for a grant
• Getting a job
• Taking out federal student loans

It is important that you provide for your own financial well-being first, even if that means contributing less than you’d like to your kids’ education. And if you end up with a surplus of retirement savings, you can always pay off a child’s student loan debt at a later stage.

Another great way of saving for your kids, is to hire your children to help in your business.

As of 2018 your child can earn up to $12,000 before they owe any taxes.

The savings to you are substantial. If you are in the 25% tax bracket and say a 5% state rate you save over 40% when you include the self-employment tax of 15.3%.

If your business is taxed as a sole proprietorship you don't owe Social Security or Medicare taxes on your child's wages until they reach the age of 18. (This same rule applies if your business is taxed as a partnership and you and your spouse own all partnership interests).

To verify your deduction and audit-proof your return, keep a timesheet showing dates, hours, and services performed. Pay your child by check and deposit the check in an account in the child's name. This can be a Roth IRA (my favourite), Section 529 college savings plan, or a custodial account. Money can be spent for private school tuition, summer camps, and similar expenses.

If you pay your child the $12,000 for a year your tax savings would be close to $4,800 in the example above. That's a lot of potential tax savings to discuss with your tax advisor. The goal is to reduce your tax burden as much as (legally) possible. Always remember that we all must pay taxes... but nobody says you must leave a tip.

If you are ready to create a financial plan for your future, not having time to available to do so is now a thing of the past.   Consider utilizing a Virtual Financial Advisor which will allow you to gain more control of your time and your financial security.

Thank you for reading!

Cheers,

Derek Notman