There’s no doubt that raising kids is expensive. According to a 2017 report from the U.S. Department of Agriculture, the average cost for a child through age 17 is about $235,000. That doesn’t even include the cost of college!
Fortunately, there are many good financial vehicles that help parents save and invest money for a child’s future. There’s no one account that makes sense for every family, but I’ll review the pros and cons of six of the best savings options so you know which one is right for you.
6 Ways to Save and Invest Money for Kids
- 529 college savings plan
- 529 prepaid tuition plan
- Roth IRA
- UGMA/UTMA account
- Brokerage account
- Savings account
Here’s more detail about different ways to save money for kids.
1. 529 college savings plan
Paying for college is the most common reason that parents want to save money for their kids. If you or your child know that college is in the future, one of the best options is a 529 college savings plan.
With a 529 plan, you make contributions and invest them in a menu of options, such as mutual funds. Your money can be withdrawn tax-free when it’s used for education expenses, such as tuition, fees, books, required equipment, and room and board.
Funds in a 529 plan can be used at any accredited school in the country, and even at some foreign institutions.
Funds in a 529 plan can be used at any accredited school in the country, and even at some foreign institutions. For instance, you could live in New York, participate in a Florida 529 saving plan, and use the money to pay for a school in California.
Plus, starting in 2018, 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.
Everyone can use a 529 savings plan because there’s no restriction on annual income. The maximum amount you can contribute each year varies on the plan you choose, 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, who is the future student. So, if you want to save for more than one child, you generally must open an account for each of them. But you can also change a 529 beneficiary to another member of the family or roll it over to another 529 plan without triggering tax consequences.
States generally sponsor their own 529 plans and many offer additional tax savings, such as a deduction on your state income taxes for contributions. The fees and benefits—such the maximum contribution limit, investment options, and in-state tax benefits—vary. So, it’s important to do your homework and compare plans across the country using sites like Collegesavings.org and Savingforcollege.com.
To sign up for a 529 you can go directly to the plan manager or use a financial advisor. No matter if you contribute $10 a month or $1,000 a month to a 529 plan, the sooner you get started, the easier it will be for you and your family to pay for college.
Pro: Due to all the benefits that come with a 529 plan, such as tax advantages, flexibility, and high contribution limits, it gets my vote for the best account to save for education costs. Additionally, distributions get favorable treatment because 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 a 10% penalty. So never contribute more to a 529 than you believe your child will need for the total of his or her 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 you like the idea of setting aside money for a child’s education, but don’t want any investment risk, check out a 529 prepaid tuition plan. They’re 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.
Funds in a prepaid plan may be withdrawn so you can use them at an out-of-state school or at a private college.
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 room and board, books, supplies, and computer equipment.
Pro: A 529 prepaid tuition plan doesn’t require you to choose investments or deal with any stock market volatility. Also, it’s not a factor in the calculation for the following year’s financial aid eligibility.
Con: The major downside to a 529 prepaid plan is that if the beneficiary chooses an out-of-state school, you must pay the tuition difference out of pocket, and may not get the full value of the plan. Just like with a 529 savings plan, you must pay income tax plus a 10% penalty on funds spent on non-qualified expenses. And you must wait until your child is born and has a Social Security number to set him or her up as a plan beneficiary.
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3. Roth IRA
I’m a big fan of the Roth IRA (Individual Retirement Arrangement) 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.
Parents can give their child a financial head start by opening a Roth IRA in the child’s name.
Contributions to a Roth IRA are not tax deductible, but you can invest them in a broad menu of options, and withdrawals in retirement are completely tax free. Additionally, since you pay tax upfront, you’re allowed to withdraw original contributions at any time and for any reason, including a child’s education.
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 (a retirement account can never be owned jointly or owned for someone else).
But for a minor (or anyone) to qualify for an IRA, he or she 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, you or your child can contribute as much as he or she made, up to the annual limit, which is currently $5,500. But you can’t fund an IRA for an infant or 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.
Pro: A Roth IRA offers flexible withdrawals of original contributions for college expenses. 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. So, 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 custodian.
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 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, such as TD Ameritrade, Swell, or Ally Invest. You 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 squirrel away money for a child’s future. Problem is, it doesn’t come with many benefits. For example, you get very low rates of interest, and what you do earn is taxed as income.
If you open a savings account in a child’s name or your own, also consider using another account that offers more aggressive growth, such as a 529 plan, a Roth IRA, or a regular investing account.
These vehicles help you beat 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.
If you save $100 a month for 20 years in a bank savings that earns 0.25% interest, 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: The only advantage of a bank savings account is complete safety from investment risk.
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.
When Should You Start Saving Money for Kids?
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!
A word of caution: Don’t get antsy and forgo saving for your own retirement to pay for college. Instead, create a financial plan that includes both college and retirement savings as soon as you start a family.
The sooner you start saving the less stress you’ll feel both psychologically and on your budget. And if you 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 sacrifice your own financial security for your kids’ college, you may find yourself relying on them to support you in your old age! While it might seem coldhearted for a parent to refuse to pay for a child’s education, don’t forget that kids have options, such as:
- Attending a relatively inexpensive state school or community college
- Applying for a grant
- Getting a job
- Taking out federal student loans
- Qualifying for a scholarship based on scholastic, athletic, or philanthropic achievements
But there are no loans or grants to support you after you stop working—except perhaps a meager Social Security income or a windfall inheritance. If you’re less than 20 years away from retirement and you have not reached 80% of your savings goal, don’t sacrifice a penny for college.
You must 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 down the road.
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