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February 16, 2021Retirement Wealth
We all love our children and want to prepare them for the future as best we possibly can, right? Of course we do! What are the best ways to invest for your children?
Deciding how to best invest for your children’s future can be a daunting task. Should you set money aside for college? Is it possible to start investing for their retirement early? Or should you just stash away cash and give it to them later in life? In this article we’ll address all of this and more to make it as easy as possible to start investing for your children.
The best ways to invest for your children is to cover all bases and prepare them for their whole life. Using tax-advantaged accounts like 529 plans, ESAs, Roth IRAs, and UGMA accounts, you can set your child up for success at all times during their lives.
Much of the information in this article comes directly from government sources such as the IRS and various laws that have been passed. This research combined with the extensive knowledge and experience of our team ensures that everything you read here is tried and true. These are truly the best ways to invest for your children’s future!
Table of contents
Although you may not think of an Individual Retirement Account (IRA) as a typical investment vehicle for kids, they are one of the best ways to invest for your children! For the exact same reasons that you would want to invest in an IRA yourself, your kids can benefit from them as well. Although kids have the same availability to use a traditional or Roth IRA, we will focus on the Roth IRA for children. For your children to have an IRA, you’ll need to open a custodial IRA in their name.
So what does that mean and how does it work?
A custodial IRA is just an IRA that you open for your child since they are not old enough to open and manage one for themselves. But once they reach adulthood (18 or 21 depending on the state) the accounts will become entirely theirs along with all the money inside. So before they’re adults, you will technically be the account owner and manager, but it’s no harder to open than your own.
Within a custodial Roth IRA, you will contribute to the account with after-tax dollars. This will enable your child to enjoy entirely tax-free growth when they end up withdrawing the money during their retirement. This tax-free growth will set them up for financial stability during their golden years. As a bonus of the Roth IRA account type, your child will also be able to withdraw the contributions at any time during their life with no penalties or tax if they ever need the cash.
Many brokerages do not offer the ability to open a custodial IRA, but a couple of bigger ones do including Fidelity and Charles Schwab. Although it’s easy to open a custodial IRA and get your child set up for success, there are of course rules and limitations that must be adhered to within the account.
A custodial Roth IRA can only be contributed to if your child has earned income. This doesn’t mean that you can contribute since you have earned income. Since the account is technically theirs, they have to have earned income of their own for any contributions to be allowed to be made to the account. Earned income is pretty much just any income that is taxable. This could be from a W-2 job, dog walking, baby sitting, etc.
So even though there are no age limits for a custodial Roth IRA, the child must be old enough to at least be earning some sort of earned income. And once they have earned income, the total contributions made to the account cannot be more than their earned income. So if they made $2,000 in a year and you matched their contributions dollar for dollar, the most you could both do is $1,000 each ($2,000 combined).
Along the same line of contributions, don’t forget about the maximum contributions allowed by the IRS. Not only is the contribution amount limited by the earned income of your child, but it’s also limited by the IRS. As of 2021, the IRA contribution limit is at $6,000 per year. So even if your child earned $10,000 during the year, they’d still be limited by the $6,000 maximum contribution limit from the government.
One of the most prevalent regrets in a young person’s life is the amount of student debt that they have when they’re finished with school. Sure the college experience was great and they learned a lot while there, but looking back, was it really worth the tens of thousands (or hundreds of thousands) of dollars worth of debt that they now have to pay back?
In fact, student loan debt has surpassed credit card debt and consumer debt as it has skyrocketed to over $1.7 trillion across the country. As you’re reading this, you may very likely have some student loan debt of your own and you know all too well how difficult it can be. Wouldn’t it be nice to be able to help your children out with their education costs and prevent them from feeling the same regret and pressure later in life?
Of course it would be! And there are some tax-advantaged programs out there that enable you to do exactly that. So let’s take a look at two of the most common options out there when it comes to investing in your children's education — 529 Plans and Education Savings Accounts.
Probably the more well-known of the two education accounts we’re taking a look at, a 529 plan is a tax-advantaged way to set money aside for your children’s education later in life. 529 plans — aptly named for the section in the IRS code that explains the tax rules and benefits — are different state by state. As state run programs, you can even shop the 529 plans state to state to find the ones with the best rates and lowest fees.
These plans have a named beneficiary (your child) who can use the money for any educational purposes, from kindergarten up through graduate school. 529 plans have a lot of benefits and features that other types of savings accounts and investment plans don’t have, so if you’re intending on the money being used for education purposes — including tuition, books, etc. — then it’s more than worth it to look into using a 529 plan. Let’s take a look at some of the features of this type of plan.
To start, you fund a 529 account with after-tax dollars and have a slew of mutual funds to choose from to invest in. Then later when the money is withdrawn for educational purposes, there are not any taxes due on the contributions or the earnings. Unlike many other tax-advantaged accounts, 529 plans have no annual contribution limits. You’ll just have to pay the government’s “gift tax” on anything over $15,000 worth of contributions in a year. Coincidentally, there are not any income limits on contributing to a 529 plan. So no matter what you make, you can still add money to the account.
There also are not any age limits on using the funds in the account. So if your child gets older and decides to go back to school, they can still use the money in the account no matter how old they are. Lastly, since you’ve already paid taxes on the contributions, you can withdraw them at any time for any other use. But if the withdrawals are not used for educational purposes, then you’ll have to pay a 10% penalty.
Overall, 529 plans are one of the best ways to invest for your children’s education. Their tax-free growth could end up paying for most, or all, of their college if you just invest a little each year!
One of the best ways to save for your child’s future education is by using an Education Savings Account (ESA). This tax-advantaged account is a way for you to invest for the named beneficiary (your child) who can then use the money later in life for any type of education expense. Although similar to a 529 plan, an ESA has a few key differences as well. Making it a unique investment vehicle worth exploring.
With an ESA, you are allowed to contribute up to $2,000 per year per child (a separate ESA per child) of after-tax dollars. And since you’re funding it with money you’ve already paid taxes on, the withdrawals made later will be tax-free. This includes all contributions and earnings. Unlike a 529 plan, you cannot contribute to an ESA if you make more than $110,000 per year filing single or $220,000 filing jointly. So if you make over these income thresholds, ESAs are unavailable to you.
Another advantage is that the investment options of an ESA are completely wide-open. Unlike the limited mutual fund options you have in a 529 plan, in an ESA you can invest in anything that you want. But to avoid taxes and penalties, the money in an ESA has to be used by the beneficiary by age 30. If withdrawals are made after age 30 or for anything other than educational purposes, a penalty will be due as well as taxes on the earnings.
So although they have more restrictions to keep in mind than 529 plans, they are another great option for investing in your children’s future education. Take advantage!
Although investing for your child’s education and retirement are certainly admirable and one of the best things you can do for them, those aren’t your only options. Your kids may never need all that money you’ve been setting aside for school. And retirement accounts are hard to access earlier in life without incurring additional penalties and fees. So it’s good to have more liquid options available that your children can access for anything they need money for.
One of the best account types to invest for your children without any ties to retirement or education is to utilize the Uniform Gifts to Minors Acts (UGMA). Similar to the custodial IRA above, a UGMA account uses a named custodial (typically you, the parent) and a beneficiary (your child) who will get full access to the account once they reach a certain age. But once your kid gets access to the account, they can use the funds for anything.
While on the surface that may seem a little scary when they’re younger, it can be one of the best ways to help them during the expensive times of adulthood. Instead of drawing on retirement accounts or going into debt, having an account set up for them to help pay for a wedding, student loan debt, or a down payment on a house, for example, will be a huge burden off their shoulders.
One of the main things to keep in mind before opening a UGMA account is that the money can’t be withdrawn without penalty until 5 years since the first contribution was made. So you wouldn’t want to open a UGMA account if you’re planning on your child using it in the next couple of years. In that case, just stash money away for them in something a little more accessible like a money market account or even a standard savings account.
Until your child reaches a certain age (18 or 21), you will be considered the custodian and have total control over the account. So you can fund it, invest in what you choose, and do with the account whatever you want. But once your child hits the age limit and gains access to the account, they will assume complete control of the money and the investments within.
While UGMA accounts do offer the laundry list of tan benefits that some of the other investment vehicles you’ve read about so far, they do have some advantages over a regular savings account. Since the account is in your child’s name, the earnings within it is taxed at a lower tax rate than yours. Depending on certain situations and circumstances, it may even be taxed at just the “kiddie tax” rate which is significantly lower than your standard tax bracket.
With UGMA accounts, there are also not any contribution limits. So you can theoretically contribute as much money as you want and your child will be able to benefit from that when they gain access to the account. The first $15,000 you contribute to the account are tax-free, but after that you will have to start paying the government’s “gift tax”, so keep that in mind.
As alluded to above, another benefit of these accounts is that the money can be used for anything at any time (after 5 years). So your child does not have to wait until they’re 59 ½ to avoid penalties like the IRA, nor are they limited to only education-related expenses. Any time they need the money and for anything they like, your child can sell the investments within and use the money any way they like.
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We love planning for retirement. It's somewhat of a hobby, and we want to share what we've learned with you. Over the years we've found the best ways to live, how to travel, take on new hobbies and give back. Happiness in retirement is the main goal, and having the right information allows us (and you) to achieve that.
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