Four options to save for your kids or grandkids
1. 529 College Savings Plan
One of the more popular accounts for kids is a college-specific account, the 529 College Savings Plan. If your goal is saving for future college expenses, the 529 Plan is the first place to look.
This type of account is owned by the parent, and a single child is named “beneficiary” of the account. The beneficiary is the child for whom future withdrawals are made.
Withdrawals for college expenses (tuition, room & board, and other qualified expenses) are tax-free, making these accounts attractive. As such, a 529 Plan is like a Roth IRA for college expenses.
529 Plans are administered by states. The state partners with an investment provider. This doesn’t mean you have to use your state’s 529 Plan, but it’s a good place to start. Arizona’s 529 Plan is managed by Fidelity.
Pros of a 529 Plan:
- Tax-free withdrawals if used for qualified college expenses
- Ability to use up to $10,000 per year for K-12 education
- Various investment options (including hands-off “age-based” mutual funds) to allow for account growth
- Extremely high contribution limits
Cons of a 529 Plan:
- Less flexibility if not used for education expenses (you can, however, change the beneficiary of the account to another child)
- Penalties for non-qualified withdrawals
- Balance in 529 Plans count against your Expected Family Contribution (EFC) when applying for financial aid
2. Brokerage or Mutual Fund Account (owned by you)
If funding future education expenses is not your goal (or if you just want more flexibility), then consider opening a “regular” investment account. By maintaining ownership of this account, you maintain ultimate flexibility. After all, the account is yours with no predetermined requirements of where this money needs to go.
By “regular” investment account, I mean opening a brokerage account or a mutual fund account. You can put as much or as little money in there as you want. Furthermore, withdrawals can be taken at any time.
Pros of a brokerage account:
- Ultimate flexibility
- Ability to invest in almost anything
Cons of a brokerage account:
- You will get a 1099 each year for dividends, interest, and capital gains incurred during that year
- Withdrawals will be taxed as capital gains
3. UTMA Custodial Account
If you like the idea of a brokerage account but plan to build a nest egg that you will later gift to your child, consider a custodial account.
The Uniform Transfers to Minors Act (UTMA) is a law that allows minors to receive monetary gifts without needing a court-appointed guardian or a trust. Though it sounds complex, it is quite simple.
An account is opened in the child’s name (yes, the child is the owner). However, you appoint yourself as custodian of the account. This means you manage the account for the benefit of your child. This arrangement stays in place until the child reaches 18 or 21 years old (check with the laws of your state).
Gifts made to a child’s UTMA account are irrevocable, meaning you can’t take it back. Withdrawals cannot be made for things that a parent should normally be expected to provide (e.g., food and clothing). However, purchasing a car for the child and college expenses (“extra” things) are permissible.
Pros of a custodial account:
- Easy to set up and maintain
- Dividends, interest, and capital gains are reported as the minor’s income
- Ability to invest in almost anything
- For high-net-worth individuals (including grandparents), gifts to minors leave their estate (which can lower future estate tax)
Cons of a custodial account:
- Less flexible, since gifts made to the account are irrevocable
- Account must be transferred fully to the child at 18 or 21, even if you feel he/she is not “responsible enough” to get this money
- Assets owned by the child are counted against you more when applying for college financial aid
4. Whole Life Insurance
A lesser-known concept to save for your kids or grandkids is to purchase a whole life insurance policy on them.
In this scenario, a parent or grandparent is the owner and premium payor, while the child is the insured. In addition to providing a death benefit, there is also guaranteed cash value growth in the policy.
The policy can be gifted to the child when he/she is an adult. The cash value can be accessed through withdrawals and loans to help pay for things like college expenses, a wedding, or the purchase of a home.
Pros of whole life insurance:
- Conservative, guaranteed growth of cash value
- Ability to fund the premiums over shorter term periods (e.g., 10, 20 years), giving the child a “paid-up” policy when he/she becomes an adult
- Cash value can be accessed tax-free
- Cash value is not considered when applying for financial aid for college
Cons of whole life insurance:
- Cash values early in the policy are slow to build
- Long-term value of whole life insurance can be hard to communicate to a young adult, and he/she is likely to terminate the policy without an understanding of that value
Better options than savings bonds
I remember when I worked at a credit union and young people would bring in stacks of Savings Bonds to redeem. These bonds were a popular way for the older generations to save for their grandkids. Since interest rates collapsed, the use of Savings Bonds has also declined. Fortunately, these four ways to save for the future generation are all great options, depending on the goal of your savings.