I am investing for primarily two reasons. First, I want to save for our retirement. Second, I want to make sure that my kids can graduate debt-free. This week I share my experiences about investing options for saving for kids’ education, what type of accounts we can use and where to open those accounts. There are four types of investment accounts that you can use to invest for kids.
529 plan is a tax-advantaged savings plan managed by individual states to encourage savings for future education costs for your children. So, you can invest a fixed sum every month or a lump sum amount through your state and that amount can be invested in Index funds (investment options are limited) and over time, that money can compound and as long as you use that money for education (K-12 and college), you never pay any taxes on the growth of those investments. So, this account works like a Roth IRA as long as you use this money for education related expenses.
Pros of 529 Plans
– In general, you can contribute up to $30,000 as a married couple to a 529 plan. There are ways that you can contribute even more than $30,000 per year if you can spare the cash.
-There are no income limits to contribute. No matter how much you earn, you can still contribute to 529 plans.
-Most states allow a tax deduction for your contribution to a qualified 529 plan. For example, Arkansas taxpayers can deduct up to $10,000 for a married couple for 529 contributions. Note that you can contribute more than $10,000 to this plan but your taxable deduction is limited to $10,000 per year.
-Anyone (parents, grandparents, uncles) can contribute to this plan. You can use just one account for multiple children. You don’t need to open separate accounts for your children.
-Unused money in 529 plans can be transferred for anyone in your extended family. You don’t have to withdraw money at a certain age.
Cons of 529 Plans
-Investment options are pretty limited. You can only invest in a limited selection of mutual funds/index funds. You cannot invest in individual stocks. This is one of the biggest drawbacks of a 529 plan in my opinion.
-If you use the money in 529 plans for anything other than education, you will have to pay a 10% penalty on the earnings of the 529 plan. Note that this penalty is only on the earnings portion of the investment. There is no penalty on the amount that you contributed. For example, if you contributed $4,000 and that money grew to $6,000. The penalty is only on the $2,000 gain on your investments.
A 529 plan can be a great way to save for college. Used wisely, by investing less than $500 per month from the time your child is born to when she goes to college, you can afford to send your child to an Ivy-league college.
Where to Open : Usually each U.S. state has their own 529 investment plan. You can just google your state 529 plan and it will take you to your state plan. This website provides a comparison of 529 plans in various states. Remember that you don’t have to live in a state to contribute to the plan for that state. For example, you can invest in the plan for New Hampshire even if you live in Arkansas because you like the investment options under that plan better. The only problem is if you do that, you won’t get the tax deduction offered by the Arkansas State. If you live in a state that does not offer a state tax deduction for 529 plan contributions, then you can invest in any other state’s plan.
Coverdell ESA Plans
Coverdell Educational Savings Accounts (ESA) are very similar to a 529 plan in the sense that you can use money from this account to pay for K-12 and college education without paying any taxes on the gains. The difference is that you can only contribute up to $2,000 in a Coverdell plan and there are a variety of investment options available under Coverdell that are not available under 529 plans.
Pros of Coverdell as compared to a 529 Plan
Variety of Investment options. You can open this account with any broker and buy any type of security in this plan.
Cons of Coverdell as compared to a 529 Plan
-There are income limits to contribute. In the year 2020, if you are married filing jointly, you can contribute to a Coverdell only if your Modified Adjusted Gross Income is less than $220,000.
-Coverdell assets must be used by the family before the student turns 30 years old. At that point, any unused funds will be distributed to the beneficiary and the gains will be taxed.
-There is no tax deduction for your contribution to the Coverdell ESA unlike 529 plans where most states allow some sort of tax deduction for your contribution.
When I started exploring these accounts, I was confused and I found navigating these accounts pretty difficult. However, if you have children and you want to save for their college, the important part is that you should start as soon as possible. Start with a 529 plan since your investment options are limited and you will start with an index fund. Give it a few years and as you become comfortable, you can open a Coverdell account as well if you like. In general, the two restrictions (income and contribution limits) on the Coverdell ESA plans reduce their popularity compared to 529 plans. You can have a 529 plan as well as a Coverdell ESA for your children. The important part is to start soon and let compounding work its magic.
UTMA/UTGA Brokerage accounts
Uniform Transfers to Minors Act (UTMA) or Uniform Gift to Minors Act (UGMA) are both custodial accounts where the adults can transfer assets to a minor. These accounts serve as a trust that holds the assets during the recipient’s childhood. The account will become the property of the child when she or he reaches the age of majority, which is typically from 18 to 21 (different for each state, you can check your state here).
This is an irrevocable transfer which means that once you deposit funds into these accounts, you cannot access or withdraw the money. It becomes the property of the minor recipient and they also cannot access the money until they come of age. Once they are 18 or 21 (depending on the state that you live in), the money becomes theirs free of any restrictions.
Usually, the parent can act as custodian and manage investments in these accounts. The custodian can also withdraw funds to cover expenses related to the welfare or education of the minor recipient. Both of these accounts (UTMA/UGMA) are largely similar in operation and intent. UGMA account is limited to financial products such as cash, bonds, stocks, mutual funds, ETFs, etc. whereas an UTMA account can hold any form of property (including real estate, cars or a family home). UGMA accounts are the more popular of the two and have been adopted by every state. This website provides adoption of these two accounts by each state.
You can start with small amounts for your children. The investment options for these accounts are unlimited. You can invest in any stock, bond, index fund, ETF etc. Here you can manage the investment choices yourself and try to invest in a stock that you can leave alone for decades and enjoy the benefits of compounding. When your child is a little older and you want to teach them about investing, you can ask them to research a stock where you can invest their birthday money and then track it every year.
There are several advantages of opening these custodian accounts. First advantage is the ease and security. You can set up a long-term trust for your children without having to pay for lawyers and formal custodians. This money is also safe from your creditors. Second, this account will keep money out of the hands of teenagers. Children will get ownership of these accounts when they reach adulthood. Finally, the biggest advantage is that children have the longest time horizon for investing, so they can enjoy compounding for decades and learn investing and managing their money in the process. These are not tax-deferred accounts meaning all realized gains are taxed at the children’s income tax rates in most cases. However, if you are setting these accounts correctly, you can aim to invest for ultra long-term where there are no realized gains because there are no sales of securities.
Roth IRA for kids
I would like to think that I saved the best for last. The last type of account that I want to talk about for children is Roth Individual Retirement Account (IRA). I believe that everyone who has earned income should have a Roth IRA. In my opinion, a Roth IRA is the second-best investment account. You can open a custodial Roth IRA for somewhat older children (above 10 years old until 18 or 21 years old depending on state ) if they have any earned income. They can have earned income from gigs such as lifeguarding at local pools, baby sitting, mowing yards, house sitting etc. If you own a business, you can employ your kids and pay them. You can also pay them for household chores and use that money for investing in the Roth. There are some creative ways that you can use to fund a Roth IRA for children. As long as their earned income is below the standard deduction, you don’t have to file a tax return for them. However, you must have accurate records for starting and maintaining a Roth IRA for children.
Contributions to this account cannot exceed a child’s earnings or $6,000 per child per year whichever is greater. There is no minimum to open this account. You can open both of these accounts with as low as $100. If you think $100 is small, then consider this fact: $100 invested in Netflix in early 2010 has grown to $5,400 approximately in 10 years.
The benefits of a Roth IRA for children is that you will never have to pay any taxes on this money if it is less than the standard deduction. Once the money is in a Roth IRA, you can invest it for long-term and let the money grow. One thing to keep in mind is that the letter “R” in a Roth IRA account refers to Retirement, that means that this account is intended to be a retirement account. So, it is a little tricky to access this money before the child turns 59.5 years old. You can access only your contributions part anytime, however, if you want to withdraw the gains, you have to wait until the child is 59.5 years old to do it penalty-free and tax-free.
When I first found out about these accounts, all this information was intimidating for me and I was overwhelmed. I even remember thinking that whether this much complexity is worth the hassle. But when I worked on the numbers, I figured out that these accounts can save me tens of thousands of dollars over the long-term. What’s more is that I can teach some investing skills to my children using these accounts so I opened these accounts. If you need a little hand-holding in starting any of these accounts for children or for yourself, I can help.
If you are a visual learner, I have also recorded a video on this topic that you can check out here.
Are you investing for your kids? Are you using any of these four options or if you are using any other option, feel free to share that below.