ôô

6 Ways to Save and Invest Money for Kids

Find out how to use six accounts to save for your child's future. Laura reviews the pros and cons of each and gives tips to fit saving for a child into your big financial picture.

By
Laura Adams, MBA
10-minute read
Episode #680

Heather Q. says:

I love the Money Girl podcast! I just opened a 12-month CD for my daughter and plan to give her the money when she’s an adult. But I have about eight more years to save for her. Should I open new CDs as I save more, or should I add money to the same CD once it matures?

Thanks for your question, Heather! I know your daughter will be thrilled to have a financial leg up as she launches and becomes independent. If you also have children or are thinking about starting a family, it’s essential to get familiar with strategies and accounts that make it a little easier to save and invest for your kids.

This post will answer Heather’s question by reviewing six savings options and the pros and cons for each one. Plus, I’ll discuss when to begin saving for a child’s future and how it should fit into your big financial picture.

When should you begin saving for kids?

Being a parent means you've got plenty of expenses and maybe ongoing financial stress. You want the best for your children, but you also need to make wise decisions for your own future. While the cost of college seems to rise faster than hot air, we're living longer and may have less Social Security retirement income to count on in the future. That means you likely need a bigger nest egg than you think.

My point is that you should never forgo saving for your retirement to pay for a kid's college or any other significant expenses. Instead, create a financial plan that includes your retirement and savings for kids as soon as you start a family.

The sooner you begin saving for short- and long-term goals, the less stress you'll feel in your budget and emotionally. If you get a late start and can't afford to pay for a child's education, don't feel guilty about it. Remember, putting retirement first is in your entire family's best interest.

If you sacrifice your financial security for your kids, you may find yourself relying on them to support you in your old age!

If you sacrifice your financial security for your kids, 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 working, getting scholarships, and taking out federal student loans.

But there no loans or grants to support you after you stop working. If you're less than 20 years from retirement and haven't reached 80% of your savings goal, stay exclusively focused on building your retirement nest egg.

Again, shore up your financial well-being first, even if that means saving nothing or less than you'd like for your kids. Ideally, you should regularly save at least 10% to 15% of your gross income for retirement before saving for your kids.

You might end up with a surplus of retirement savings. In that case, you could always help a child by paying off their student loans or any other debts down the road.

6 ways to save and invest money for kids

When the time is right to save and invest money for your kids, here are some great options.

1. Use a bank savings account

An FDIC-insured bank savings account is one of the safest places to squirrel away money for a child's future. The problem is, it doesn't come with many benefits. A regular savings account pays low interest, and what you earn gets taxed as income.

If you have a large amount to save, consider getting a high-yield savings account, which pays double or triple compared to regular savings. However, what you earn is still relatively low compared to other options we'll cover.

For example, if you save $100 a month for 20 years in a bank account earning 0.25% interest, you'd accumulate less than $25,000. But if you put the same amount in high-yield savings making 2%, you'd have almost $30,000 after two decades.

If you're like Heather, you might consider opening a CD with a bank or other financial institution for even higher returns. CDs can be FDIC-insured, and they're also extremely safe.

With a CD, you loan money to the institution, which lends it to their customers, and you receive a set rate for a period, which is called the term. CD terms can range from a few months to a few years. In general, the longer the term, the more interest you receive. When the term is up, you receive your initial deposit plus any interest accrued.

Heather wants to know if she should add money to her 12-month CD when the term is up (known as the maturity date) or get a new CD. In general, traditional CDs do not allow you to add money after your initial deposit, so she'll need to open a new CD.

However, there are many different types of CDs. One is called an add-on CD, which does allow you to make a set number of deposits during the certificate's term. So, if Heather has an add-on CD, she could make multiple deposits before it matures.

Pros and cons of bank savings accounts

Using FDIC-insured bank savings, high-yield savings, or a CD means that it's entirely safe from investment risk. In exchange for safety, they pay little interest. That means you could be leaving many thousands of dollars on the table compared to investing the funds. Also, you must include the account's value in the calculation for future financial aid.

2. Open a 529 college savings plan

Paying for college is the most common reason parents want to sock away money for their kids. If you or your child know that college is in the future, one of the best options is to open a 529 college savings plan.

With a 529, you contribute funds on any schedule you like and choose how to invest them from a menu of options, such as mutual funds. The funds can be withdrawn tax-free if you use them to pay qualified education expenses, such as tuition, fees, books, required equipment, and room and board.

Funds in a 529 plan can be spent at U.S. accredited schools and even at some foreign institutions. You could live in Florida, participate in a New York 529 saving plan, and use the funds to send a child to college in California.

Funds in a 529 plan can be spent at U.S. accredited schools and even at some foreign institutions. You could live in Florida, participate in a New York 529 saving plan, and use the funds to send a child to college in California.

Thanks to the Tax Cuts and Jobs Act, you can spend up to $10,000 per year tax-free on elementary and secondary school expenses. That gives parents the flexibility to withdraw funds for tuition and other education expenses for a younger child attending a public, private, or religious school.

You can use a 529 no matter how much you earn, and the maximum annual contribution limit depends on the plan you choose but could be over six figures per student!

Funds in a 529 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 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 as the maximum contribution limit, investment options, and in-state tax benefits—vary considerably.

To sign up for a 529, you can go directly to the plan manager, use a financial advisor, or start doing your homework at sites such as Savingforcollege.com and Collegesavings.org.

Pros and cons of 529 college savings plans

Due to the benefits that come with a 529—such as tax advantages, flexibility, and high contribution limits—it gets my vote as the best account to save for a child's education. Additionally, your 529 distributions get favorable treatment because they're not considered income in the calculation for financial aid.

529 college savings plans get my vote as the best account to save for a child's education.

The main drawback is that if you use a 529 for non-qualified education expenses, you'll have to pay income tax, plus a 10% penalty on those withdrawals. So never put more in a 529 than you estimate your child will need for their total education expenses. Also, note that you can't start funding a 529 until your child is born and has a Social Security number.

3. Enroll in a 529 prepaid tuition plan

If you want to save for a child’s education without taking any investment risk, check out a 529 prepaid tuition plan.They allow you to save money by locking in today's tuition costs for the future.

Prepaid plans are offered by certain institutions and nine states, including Florida, Maryland, Massachusetts, Michigan, Mississippi, Nevada, Pennsylvania, Texas, and Washington. There's also a national Private College 529 plan you can use no matter where you live to lock in tuition at about 300 private colleges and universities across the country.

When you open a prepaid plan, you must name your student, who is the beneficiary. But you don't have to pick a school until your student is ready to enroll. You can even change plan beneficiaries if you have another potential student in the family.

You can even have a 529 prepaid plan and a 529 college savings plan for the same beneficiary. Your prepaid account would pay tuition, and your savings plan would be for other qualified expenses, such as room and board, books, supplies, and computer equipment.

Pros and Cons of 529 prepaid tuition plans

A 529 prepaid plan doesn’t require you to choose investments or be subject to market volatility. Also, it’s not a factor in the calculation for financial aid eligibility.

If the beneficiary wants to attend a school that accepts a portion or none of the funds, you must pay the tuition difference out of pocket.

The major downside to a prepaid plan is that if the beneficiary wants to attend a school that accepts a portion or none of the funds, you must pay the tuition difference out of pocket. In other words, there’s a risk you might not get the total value of the plan.

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 them up as a prepaid plan beneficiary.

4. Use a UGMA/UTMA account

What if you want to save money for a child for non-education expenses?  In most states, minors can't own investments and financial products in their names. That means parents can't just give investments or transfer assets to a minor child without creating 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). They allow investments for minors, such as mutual funds and real estate, to be held in the care of an account custodian.

You can set up a custodial account at most banks and brokerage firms, such as Fidelity or Vanguard. Then you can make withdrawals to cover expenses that benefit a child. And when they become an adult (usually 18 or 21, depending on your state), the trust assets automatically transfer into the child’s name.

Pros and cons of a UGMA or UTMA account

The main benefit of using a UGMA or UTMA account is that you can give a child as much money or assets as you like. There are no annual limits, and you can also withdraw funds at any time and for any reason. A portion of the account's investment earnings gets taxed at your child's income tax rate, which can reduce taxes.

Once the child reaches the age of majority, parents have no control over how the child spends the funds.

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 the funds. Also, custodial accounts are considered an asset of the child, which means they're a more significant factor in the calculation for financial aid than if owned by a parent.

5. Get a life insurance policy

An often-overlooked way to protect a child's financial future is to purchase life insurance. It's a contract that pays one or more beneficiaries after the policyholder's death.

An often-overlooked way to protect a child's financial future is to purchase life insurance. It's a contract that pays one or more beneficiaries after the policyholder's death.

There are two main types of life coverage, term, and permanent policies. A term policy pays a cash benefit if you die within a period of 10 or 20 years. And a permanent policy covers you no matter when you die, and it may also accumulate a cash value. You can tap the accumulated value or allow it to grow for a child.

If you're relatively young and healthy, a $500,000, 20-year term life policy may only cost less than $20 per month. It's wise to cover both parents, especially if one is an at-home caretaker. If a stay-at-home parent dies, the cost could be significant. 

If you get life insurance through work, it may not be enough. Most companies offer coverage in an amount equal to one or two times your annual salary. Depending on your financial needs and family size, having life coverage in an amount equal to ten times your income is a good rule of thumb.

Also, remember that if you leave your job or get terminated, your life coverage will end. Since you can have multiple life policies, it's wise to maintain your own insurance, in addition to any you may get through work. You can get free quotes at sites like EffortlessInsurance.com and Policygenius.com.

Pros and cons of getting life insurance

Every parent should have life insurance so their child would be financially secure in the event of their death. The beneficiary would receive a lump sum payment from a term policy or get an amount plus additional cash value accrued in a permanent policy.

The downside of life insurance is that it typically doesn't provide a benefit until the policyholder dies. However, if you have a permanent policy that builds cash value over time, you could tap it to pay expenses for a child, such as education or a vehicle.

6. Contribute to a Roth IRA

A Roth IRA (Individual Retirement Account) is one option to help an older child save money. Unlike other retirement accounts, you can spend the original contributions (but not earnings) in a Roth IRA before retirement without having to pay taxes or a 10% early withdrawal penalty.

Contributions to a Roth IRA are not tax-deductible; you can only add money on an after-tax basis up to an annual limit. You choose how to invest the balance using a menu of options, such as mutual funds.

Many people don’t realize that kids can have an IRA if they have earned income from a part-time job or self-employment income.

Many people don’t realize that kids can have an IRA if they have earned income from a part-time job or self-employment income. As a parent, you can make an IRA contribution on your child’s behalf for as much as they earn up to the annual limit, which is currently $6,000.

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 to save and invest.

However, if you have a young or non-working child, another option is to fund your own Roth IRA and then take withdrawals to pay expenses for your child. There is an annual income limit to qualify for a Roth IRA, so if you’re a high earner, you may not be eligible to make contributions.

It’s easy to open a Roth IRA for a minor at most major banks, brokerages, and investment companies such as USAA and Betterment.

Pros and cons of contributing to a Roth IRA

A Roth IRA offers flexible withdrawals of original contributions for college or any expenses you like. Unlike a 529 savings plan, if you don't need some or all the money for college, you can leave it in the account. And the balance is not counted in the calculation for financial aid.

However, if you withdraw the earnings portion of a Roth IRA before age 59½, you typically must pay income tax and penalties unless you qualify for an exemption. Also, withdrawals don't count as income for financial aid eligibility.

What questions do you have about saving for a child or your future? Please leave me a voicemail by calling 302-364-0308.

About the Author

Laura Adams, MBA

Laura Adams received an MBA from the University of Florida. She's an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura's previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.