Saving For Your Kids Beyond A 529 PlanSubmitted by Castlebar Asset Management on March 19th, 2015
Parents are well versed with 529 plans as a tool to save for college. One of the most frequently asked questions I get from parents are what other options are available outside of 529 plans. Some parents want to have flexibility to save so this money can be used beyond education. It could be used to pay for their first car, to put a down payment on your child’s house or start your kids off on the right foot after they graduate from school. Here are some alternatives to 529 plans to save for children.
Custodial Accounts: Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA)
The most straightforward investment account is a UTMA or UGMA. These are investment accounts that offer some decent tax breaks but you will give up control to your children at a specific age. The money contributed to these accounts “must be used for the benefit of the minor.” If your intention is to gift some money to a child this is a simple way to accomplish it without creating a trust.
The tax rules work in your favor. In 2015, the first $1,050 of unearned income is tax free and the next $1,050 is taxed at your child’s tax rate. Anything above $2,100 in unearned income is then taxed at the parent’s tax rate. This is better than keeping the money in your accounts and paying your tax rate.
The two less attractive features of custodial accounts are the impact on financial aid and change of control. Custodial accounts will have an impact on your child’s financial aid they receive from college. Custodial accounts are viewed as your child’s asset and are expected to contribute up to 35% of those assets towards their college expenses. If the assets were held if your name they would only count towards 5.9%.
When your child takes control of these accounts can also be an issue for some parents. Depending on the state you live, your child takes control over the account at either 18 or 21. I know when I was 18 it would have been a wildcard what could have happened to any amount of money. Some states allow the custodian to control the account until 25 if it is set up this way in advance. A list of state by state rules is here. This money can be transferred to a 529 which is a nice escape hatch if you find your child is not ready to gain control.
IRA – Traditional or Roth
If you have a teen who is earning income (even from baby sitting or yard work) the option of funding an IRA is worth looking into. A Roth IRA is the best solution because if you want to use this money for a house down payment, college or some other need before retirement they can withdraw any contribution made tax or penalty free. Gains must remain in the account otherwise they are subject to penalties and taxes. IRAs will not have any impact on your financial aids eligibility.
Coverdell Education Savings Accounts (ESA)
This is an alternative to contributing to a 529 plan and offers a few unique benefits. Coverdells allow you to contribute up to $2,000 per beneficiary in a given year. This money can be used to pay for any educational expenses. I like to highlight that this money can be used on private K-12 schools as well. You don’t receive any tax deductions for contributions but the money can be withdrawn tax free as long as it is used on education expenses. Income and gains are not taxed.
Coverdell accounts do have a limited life. The assets have to be distributed by the time the beneficiary turns 30 and could trigger taxes and penalties if not used on educational expenses. This is different than a 529 because a beneficiary can be changed on a 529 account if it is not going to be used by one person.
Parent’s Owned Account
Parents can also create a separate account which they contribute to on behalf of their children. As a parent you would own the account, pay taxes on the account and this would have limited effect on college financial aid. The benefits are you can control when you children receive any cash from this account. You can also set up a trust if you want to see this money used in a particular way or distributed at certain ages if you pass away.
These options work well for grandparents and other family members who are looking to save for your children.
Andrew Comstock, CFA
Disclaimer: The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.