A Lasting Gift — Saving for a Child's FutureSubmitted by Affiance Financial on November 29th, 2017
With the holiday season upon us, the idea of giving is everywhere. Giving gifts. Giving to charity. As a new father, I’ve been thinking about what to give my son. Sure, there will be plenty of cute baby clothes and fun toys unwrapped at our house. But what about a really meaningful, lasting gift, like paying for his future education? Or even giving him a jump start on financial independence? What better time to start saving for my son’s future than during the holiday season?
I am sure that many of you are in the same boat as me. So, I thought I would share an article on how parents, grandparents, or other family members can help the children in their lives by setting some money aside for use down the road. Here are some different ways to save for a child (For a table summary of the options click here):
A Uniform Transfers to Minors Act (UTMA) account allows for any kind of asset, which includes real estate, to be transferred to a minor. A Uniform Gifts to Minors Act (UGMA) account also allows for assets to be transferred to a minor. But unlike an UTMA, UGMAs can only hold bank deposits, securities, and insurance policies. Under an UTMA or UGMA, the donor, or an appointed custodian, manages the account until the child is of age.
One interesting feature of UTMA and UGMA accounts is that the donor can gift as much money as he or she pleases into the account. The main caveat is the potential tax implications, which should be discussed with a professional. Income in a UTMA or UGMA is taxed to the minor. The first $1,050 is exempt from federal income tax. The second $1,050 is taxed at the child’s rate. Any income over $2,100 is taxed at the higher of the child’s or parent’s tax rate.
And, it’s important to understand that all assets transferred under UTMAs or UGMAs are irrevocable. The donor is unable to change the beneficiary. And, the child will legally own the assets when he or she reaches the age of majority (usually age 21). Yes, this does mean that if the child, now legally an adult, wants to buy a brand new Porsche with the money, he or she can do it and you don’t have the legal right to say no. After all, it’s their money!
Lastly, it’s important to note that an UGMA or UTMA account may affect the amount of financial aid a child receives for college.
Coverdell Education Savings Account (ESA)
Coverdell ESAs are specifically designed to help fund a child’s elementary, secondary, and post-secondary education. They can help pay for qualified education expenses such as tuition, fees, and books, as well as certain room and board costs at eligible educational institutions.
Coverdell accounts have an annual contribution limit of $2,000 per beneficiary.* Earnings in a Coverdell ESA grow tax-free, and distributions from the account that are used for qualified education expenses are not taxed. The donor of a Coverdell account stays in control of the account at all times. But, the assets in the account must be distributed to the designated beneficiary by age 30, or transferred to another Coverdell ESA for the benefit of another eligible family member. It is also important to note that funds from a Coverdell account must be used for qualified education expenses only, otherwise a penalty will be assessed.
529 College Savings Plan
Probably the most popular tool, and the one that most families are familiar with, is the 529 College Savings Plan. A 529 plan is operated by a state or educational institution and is designed to help families set aside funds for future college costs. With a 529 plan, the donor of the plan stays in control of the account at all times. Unlike UTMAs, UGMAs, and Coverdell ESAs, 529 plans have no income limits or age limits. Another advantage is that many states have tax incentives for residents using their state's 529 plan. New in 2017, contributions up to $3,000 are deductible on Minnesota state taxes.
Investments inside of a 529 plan can be changed twice per calendar year. Beneficiaries can be changed as often as desired, at any time, for any reason, as long as the beneficiary is a qualifying family member. A 529 plan can be used nationwide, regardless of the location of the plan in which you participate. So, you can live in Arizona, invest in a Virginia 529 plan, and send your children to school in Georgia and it’s all fine. To make things even better, as long as the money in the plan is being spent on qualified educational expenses, earnings in the plan grow tax-free and distributions will not be taxed when the money is taken out.
Lastly, contrary to popular belief, 529 plans are not “use it or lose it” plans. The account owner can withdraw funds at any time for any reason from the account. The only caveat is that the earnings portion of any non-qualified withdrawals will incur income taxes (on gains only) as well as a 10% penalty.
Minor Roth IRA
In my mind, one of the most underutilized tools available for saving for a child is the Minor Roth IRA account. Minor Roth IRAs can be opened for the benefit of a child as long as the child has earned income. A parent or other donor can contribute as much as the child’s income for the year, up to the annual Roth IRA limit (currently $5,500). The donor of the plan controls the account until the child becomes an adult, at which point he or she assumes control of the account.
When the beneficiary of a Minor Roth IRA reaches the age of majority, there are a few ways for him or her to use the account going forward. Assuming, as with any Roth IRA, that the account has been opened for at least five years, the beneficiary has the following options:
- Retirement Savings — The owner (the child, now an adult) can withdraw the money after 59 1/2 years of age. No taxes will be owed on the earnings.
- A First Time Home Purchase — The owner can withdraw money before reaching 59 1/2 to buy a house. The money must be used as a down payment for closing costs. The withdrawal is limited to $10,000 of earnings and is tax-and penalty-free.
- Education Expenses — The owner can withdraw money before reaching 59 1/2 for college. He or she will pay taxes on the earnings, but it will be penalty-free if the money is used for qualified education expenses (tuition, fees, books, supplies, equipment, and most room and board charges).
- An Emergency Reserve — The owner of a Roth IRA can withdraw money they've contributed in an emergency completely tax- and penalty-free up. Any withdrawal above the amount of contributions will be subject to taxes on the earnings, plus a 10% early withdrawal fee.
I believe that the biggest gift parents can give their children is a head start toward achieving financial goals down the road. Being able to provide Liam with a jumpstart on his financial goals means more than any gift I could wrap up for him. And, as illustrated by this article, parents, grandparents, and other family members can help the children in their lives in many different ways. If you have a special child in your life, consider a less traditional, but much longer-lasting gift this holiday season. Contact your Affiance Financial advisor to get started today — It’s never too early.
*A donor’s adjusted gross income must be below $190,000 for married couples filing jointly (or $95,000 for single filers) in order to qualify for the full $2,000 annual contribution to a Coverdell ESA.
†Contributions can be withdrawn at any time tax- and penalty-free.
The views represented are not meant to be construed as advice. Moreover, no client or prospective client should assume that this content serves as the receipt of, or a substitute for, personalized advice from Affiance Financial, or from any other professional.