As a parent, you want to do everything you can to set up your children for success. Every dollar saved can help your child build a more secure and productive future. You can start saving and investing money for your kids at any age. Below I’ll talk about some of the ways you can get them started.
529 plans are education investment accounts with special rules and tax benefits that help families save for college expenses and K-12 tuition. College costs have risen throughout the years and helping your kids avoid the financial burden of loans can help solidify their future.
The 529 plan provides federal tax-free growth and tax-free withdrawals for qualified expenses. Some states offer residents a tax deduction for contributions. As the account owner you always have the right to change beneficiaries to another family member without a penalty.
The IRS does not allow you to deduct contributions from your federal taxable income, but most states allow you to deduct them from your state taxable income. The maximum contribution limits vary by state, but the limits are typical high. In Illinois, the maximum contribution limit is $450,000 and they allows an annual tax deduction of $20,000 per couple.
Roth IRAs are a common retirement account because the ability of tax-free withdrawals after age 59 ½ . A custodial Roth IRA can be opened and managed by any adult (parent, grandparent, aunt, uncle, or friend) on behalf of a minor earning income. The custodian maintains control of the account until the minor reaches a certain age. Typically, when the child turns 18 or 21, the assets are transferred to a new account under their name only.
There is no minimum age requirement to open a Roth IRA. The only requirement is that the child has “earned income”. The child will only be able to contribute to the Roth as much as they earn. Contribution to a child’s Roth IRA can be a gift from you or someone else.
Would a summer job at the local retail store count as earned income? Yes. Would a cash only lemonade stand count? Most likely not. (Be sure to always ask your tax professional). The maximum contribution in 2021 is $6,000.
Some parents choose to match their child’s earnings and make contributions themselves. For example, if your child earned $4,000 at a summer job, you can let them spend their money as they wish and make $4,000 contribution with your own money. Below shows the benefits of starting to save early towards a Roth IRA.
UTMA and UGMA
If you want an account that has the most flexibility, look into the UGMA (Uniform Gift to Minors Act) or UTMA (Uniform Transfer to Minor Act). Just like the custodial Roth IRA, the account is opened in the child’s name and a custodian manages the account until age of majority. The minor will then have full control over the assets and can use them for any purpose.
There are no limits to the dollar amount or transfers that can be made into UGMA or UTMA accounts. Amounts over the gift tax threshold will incur federal gift tax (see below). Contributions are irrevocable as well, meaning once you transfer to the minor’s account, you can’t get it back.
There is no requirement on what the withdrawals are used for. Withdrawals can be taken at any time but must be for the benefit of the minor.
A downside to this account is earnings are subject to federal income or capital gains tax. Basically, if the beneficiary’s interest, dividends, or other investment incomes total more than $2,200, part of that income may be taxed at the custodian’s tax rate instead of the beneficiaries.
If you plan to contribute to these accounts, you should factor in the gift tax limits. For 2021, you can give $15,000 ($30,000 for married couple) to someone in a year and not have to deal with the IRS. This is per recipient, not the total sum of all your gifts. Meaning you can give $15,000 to your kid, $15,000 to your neighbor, and another $15,000 to your friend without having to file a gift tax return. The lifetime limit for an individual is $11.7 million and $23.4 million for a married couple.
Remember, long term savings for your children should be invested to get the benefits of compound interest. Too many people have CDs or bonds for their kids that pay next to nothing in interest.
Starting your kids off investing at a young age can help them become more financially independent later in life. What type of account you choose depends on your situation and goals. If you have any questions, please don’t hesitate to reach out.
Disclaimers and Sources:
Chart: Fidelity Learning Center- “Turbocharge Your Child’s Retirement with a Roth IRA for Kids”
Prior to investing in a 529 Plan investors should consider whether the investor’s or designated beneficiary’s home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state’s qualified tuition program. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary. Please consult with your tax advisor before investing.
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