Birthday gifts. Christmas cards. Odd jobs and allowances. There are many ways that kids can come into money these days. And teaching them to save at an early age is an important lesson that will pay benefits for years to come. But for parents and grandparents who want to help fund the next generation’s future, questions abound about the best way to put that money to work for the little ones in their lives.
Historically, it was common to open a savings account at a local bank as a way to help children save for the future. There was a time when these vehicles paid a decent amount of interest, often in the range of 2 to 5 percent. But it has been more than a decade since a standard savings account has provided that kind of return. These days, it is more likely that a bank statement will show pennies worth of interest earned on a quarterly basis.
So what are adults to do? The good news is that you have options. Rather than sticking with a standard savings account, consider one of the following alternatives when it comes to helping kids build meaningful savings:
- UTMA investment accounts – For many parents, Uniform Transfer to Minor Accounts (UTMAs) are an option they have not explored. It is something you should take a serious look at. With an UTMA, an adult can establish an investment account in which the child is the beneficiary owner and the adult is the trustee. These accounts can be invested in any assortment of stock-based mutual funds, such as low-cost options offered by Vanguard or Fidelity. While these investments will follow the volatile path of the stock market rather than the safety of a savings account, the potential for long-term growth is worth the risk, especially for young children. Though these accounts offer many attractive options, it is important to consider tax implications – particularly the prospective imposition of the “kiddie” tax if the account generates investment income, such as dividends and capital gain distributions – and your state’s rules regarding the age that the minor attains full ownership (and decisions on when and how to use the funds) of the account, which occurs at age 18 or 21 in most states. Keep this age in mind as the funds in UTMA accounts can be withdrawn for any reason and the mind of a young adult is teeming with possibilities. As with any investment, consult with your financial planner and/or tax advisor before taking the leap.
- 529 college savings accounts – By nature, these accounts are more restrictive than standard UTMA investment accounts, in that the funds are intended to be used strictly for qualifying education expenses (think tuition, room and board, etc.). That said, a 529 plan can be a great way to help a child save for the ever-escalating cost of higher education. Though your investment options will be limited to those offered by each state’s plan, most 529s provide low-cost, index-style equity investments that can far exceed the growth of a standard savings account. As a bonus, many states offer tax incentives for those who contribute to a 529. For example, through Wisconsin’s Edvest 529 plan, a parent or grandparent can contribute up to $3,560 in 2022 and receive a reduction in their state taxable income equal to that amount. The caveats of a 529 plan are the penalties imposed on anyone who withdraws money that is not used for qualifying education expenses. Specifically, there is a 10% excise tax tacked on to non-qualifying distributions, plus the recipient must pay ordinary income tax on the gains in the account (the contributions made over time are not taxed).
- Custodial Roth IRA – This type of account is likely reserved for older children, but the benefits are substantial. Parents have the opportunity to open a Custodial Roth IRA for children who have earned income, which in most circumstances means the minor must be working a part-time job. Once funds are deposited, they can be invested in any equity offering, with the advantage of growing tax-free until withdrawn. Though Roth IRAs are intended for retirement – meaning distributions should not start until at least age 59-1/2 – children would have the ability to pull out contributions without consequence after the account has been established for at least 5 years and can also take advantage of rules that provide for special distributions related to qualifying education expenses and the first-time purchase of a home. As with a 529 plan, there can be penalties and taxes related to early, non-qualifying distributions, so educating the child on the consequences is critical.
No matter what avenue you choose, it is always a good idea to get kids thinking about saving. By using one of the accounts listed above, you can help accelerate the growth of those funds, and help a kid in your life begin the path toward a successful financial future.
Tim Neuenschwander, CPA, CFP® is the managing member of Neuenschwander Asset Management, LLC. You can click on his name to visit his LinkedIn profile or you may contact him via email at firstname.lastname@example.org.