One of the common questions our team gets from parents with children is, “How can we set up our child for financial success?” While there are a few different tools available to help benefit your children, we like to ask a few more questions to determine what tool is best fit to suit their objective. After learning a bit more about what they’re hoping to accomplish, then we determine a recommendation on which tool can help them accomplish their goal. Throughout this article, we’ll compare and contrast two different types of investment accounts that are specifically designed for children that can be used to help set them up for financial success.
Most things in life have tradeoffs, and the two investment accounts that we’ll examine in this article also have tradeoffs. In our practice, we do not believe in one-size-fits-all type of plans. That’s why we like to ask a lot of questions to make sure the recommendation that we make is suitable for you and your objectives.
The first type of investment account we’ll look at is called a 529 College Savings plan, commonly referred to as a 529 plan. The name 529 plan is named after section 529 of the Internal Revenue Code, which gives special tax benefits for these types of plans. These accounts are specifically designed to help families save for education in a tax-advantaged way. Anyone can contribute to a 529 plan, that includes parents, grandparents, or even aunts and uncles, as well as friends. For some states, contributions to 529 plans are tax deductible, but this is not the case for all states.
The money that is contributed to a 529 plan can be invested and the growth on the investments grows tax-deferred and potentially tax-free if used for qualified education expenses. To take tax-free withdrawals, the money must be used for qualified education expenses such as tuition, books, room and board. The definition of qualified education expenses has broadened in recent years to include certain private schools, post-secondary education, and vocational-technical schools as well. Not all education expenses are considered qualified, so it is important for you to discuss with your CPA or accountant to determine if your expense will be considered qualified.
For money that is withdrawn and not used on qualified education expenses, there is income tax due on the money as well as a 10% penalty. That’s why these types of accounts are only the right fit for families who want to intentionally invest funds for their children’s education. They do have some flexibility if the child decides not to go to school or has scholarships. Unused funds in a 529 plan can be changed to a different beneficiary, in the same family, who may use it without a penalty on qualified education expenses. Additionally, based on new legislation from SECURE 2.0, unused funds in a 529 plan that has been opened for at least 15 years can be rolled into the beneficiary’s Roth IRA up to the annual contribution limit with a lifetime maximum set to $35,000 for each beneficiary.
The second type of investment account we’ll look at is called a custodial account or also known as a UTMA/UGMA account. This type of account is set up by an adult, most often a parent or grandparent, for the benefit of a child. These accounts allow the custodian to manage the money in the account until a child reaches a certain age, usually 18 or 21 depending on the state. The minor is the owner of the account while the custodian manages the account.
Money that is gifted to these custodial accounts can be invested in a variety of assets including, stocks, bonds, mutual funds, and ETFs. The goal for this account rather than a savings account that is setup for a minor, is to try to grow the funds in the account given that the child will have a number of years before they use the funds. This type of account compared to the 529 account has more flexibility. Custodial accounts do not have any restrictions on how the child can spend the money once they reach the age of majority. However, it does not have tax advantages like the 529 plans do. The money in the custodial account is subject to taxes each year as income is earned, such as interest, dividends, and capital gains.
Both a 529 plan and a Custodial Account can be a powerful tool in helping set your children up for financial success. Which tool makes the most sense for your child will depend on the purpose of the money, what you value between tax advantages and flexibility, and ultimately your own financial circumstance. You must take care of yourself so you can take care of others.
-by Jacob Young, AAMS®
Financial Advisor, RJFS
313 East 10th Ave.
Bowling Green, KY 42101
Phone: 270-846-2656
Securities offered through Raymond James Financial Services, Inc., member FINRA/SIPC. Investment advisory services are offered through Raymond James Financial Services Advisors, Inc. Ben Smith Life Compass Financial is not a registered broker/dealer and is independent of Raymond James Financial Services.
Investing involves risk and you may incur a profit or loss regardless of strategy selected. Every investor’s situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. Prior to making an investment decision, please consult with your financial advisor about your individual situation.
The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of Jacob Young and not necessarily those of Raymond James.
As with other investments, there are generally fees and expenses associated with participation in a 529 plan. There is also a risk that these plans may lose money or not perform well enough to cover college costs as anticipated. Most states offer their own 529 programs, which may provide advantages and benefits exclusively for their residents. Investors should consider, before investing, whether the investor’s or the designated beneficiary’s home state offers any tax or other benefits that are only available for investment in such state’s 529 college savings plan. Such benefits include financial aid, scholarship funds, and protection from creditors. The tax implications can vary significantly from state to state. Any contributions made within the past five years to a 529 plan (and earnings on those contributions) are ineligible to be moved into the Roth IRA.
Neither Raymond James Financial Services nor any Raymond James Financial Advisor renders advice on tax or legal issues, these matters should be discussed with the appropriate professional.
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