How, if, and how much to save, if any, for your kid(s)’s education & life is a personal decision. There is no simple answer. I don’t recommend doing any of these if your finances are not in order. Remember, there is no such thing as a loan for retirement.
My 1 year old already has 3 accounts and about to open a 4th. Why? To take full advantage of time and compound interest of course. Here they are in order of when we opened them.
1. 529 College Fund
529s are the king of college savings accounts. You contribute after-tax money in, it grows tax free, and you don’t pay taxes on withdrawal. You may even get a state tax deduction for your contribution. You can also open one before your child is born! So if you know you’re going to have children and get a decent state tax break like I did when I was living in NYC, it’s not bad a idea to get one going.
Where should you open one? Start with your own state’s plan. If you get a state tax break you’ll want to find out if you’re limited to using your state’s plan to qualify for a deduction or not. A few states, including my now home state of PA, allow you to use any state’s plan. So, I’ve kept mine with NY which currently offers the lowest fee Vanguard funds. We currently invest it all in the Aggressive Growth Portfolio which consists of 70% Total Stock Market Index Fund and 30% Total International Stock Index Fund.
If your state offers no tax deduction then I recommend NY, Utah, or Nevada’s plan. Pick Nevada if you already invest in Vanguard and want to keep things clean. Don’t overthink it, just pick one. And – make sure you select the direct plan and not the plan via a financial advisor which are loaded with extra fees.
There is a penalty if you withdraw money for non-educational purposes. Because of this I recommend saving something like 70% in a 529 and the rest in either a UGMA/UTMA or your regular brokerage (aka taxable account).
There is a special rule allowing parents to frontload 529s above the gift tax limits. You may frontload 5 years worth (5 x $15,000 or $30,000 = $75,000 or $150,000). For those that can swing this, this is a great way to get that money growing for college.
2. UGMA (Uniform Gifts to Minors Act)
UGMA & UTMA are basically savings and/or investing accounts for your children. You own the account as a custodian until junior reaches the age of majority. This age is state dependent but usually ranges from ages 18-21. Once they reach this age the account belongs to them and you lose control. Since this is an asset your child owns it will be counted for college financial aid calculations.
The money can be used for anything. On the flip side, interest, dividends & capital gains are taxed. The taxation recently changed with the new 2018 Tax Law and will be taxed like trusts (15% & 20% tax above $2,600 & $12,700 respectively). Previously, the first $2,100 of unearned income (interest, dividends & capital gains ) was not taxed.
3. Coverdell ESA
Huh? That’s the usual response I hear when I recommend this account for children. I already discussed how great ESAs and how you can fund one despite being over the income limit (kind of like the backdoor Roth IRA). You can only contribute $2,000 a year but over time (and compound interest) you can have a sizeable chunk of cash to use for either private school and college. Although there is a new ruling allowing up to $10,000 per year withdrawals from a 529 account for K-12, not all states have adopted this. I also don’t recommend doing this unless 1) you get a nice state income tax deduction (like NY) and/or 2) you frontload your 529 at or near birth. Otherwise the money just won’t have much time to grow if you keep withdrawing money from it.
Unlike the 529 plan, you cannot open one before your child is born.
4. Roth IRA
We haven’t opened a Roth IRA yet but will before the end of this year. Children can open a Roth IRA if they have earned income. Chores around the house do not count. Babysitting and working for your business do. In Eggy’s case, he’s a print model for this website.
What, you think he let me use this photo for free? Nope.
A Roth IRA for your children via a family business is a win-win situation. You pay your child for work, you get a business deduction, he/she gets earned income and can open a Roth IRA. Once inside the Roth IRA, the money is never taxed again! Better yet – until he makes a sizeable income through the family business he won’t pay federal and likely no state income taxes as well!
Now, the key is to pay your child a reasonable wage for the work. It won’t pass the snuff test if I paid Eggy $5,500 for a few photos on this website.
A quick reminder to stay under the gift tax limits for total contributions to your children’s 529, ESA, and UGMA/UTMA accounts. Currently, the gift tax limits are $15,000 or $30,000 for married couples. So, in other words, don’t contribute more than $30,000 across the 3 accounts in a year. An exception to this is the 5 year frontloading exception for 529s.
We opened and kept his 529 in NY. His UGMA and ESA accounts are at TD Ameritrade. We plan to open his Roth IRA at TD Ameritade since Vanguard does not allow minor Roth IRAs.
What do you think? Comment below!