Saving For Your Children Part II: Types of Savings Accounts

“He who does not economize will have to agonize."
― Confucius

“Learning never exhausts the mind." 
― Leonardo de Vinci

In Part I of saving for your kid’s education, we discussed how the ownership of assets and you and your child’s income will affect your potential eligibility for financial aid. Today we explore the available types of accounts you can use to save for your kids.

First Things First

Before saving for your children’s future expenses other priorities should come first. Having an emergency fund (perhaps 6 months of living expenses) and saving for your own retirement (10-20% of income, depending on age, existing savings, and income) are rudimentary. Taking care of your future self financially is a part of taking care of your children. That being said, let’s move on to the various types of accounts available to save for your kids.

Taxable Accounts In Your Name

A standard brokerage account in your name provides the greatest level of flexibility for deposits and withdrawals, along with access to a large variety of investment options. You can manage this yourself, or have a professional advisor monitor and rebalance the holdings. TD Ameritrade, Schwab, and Vanguard are among the many investment banks that offer these accounts with full variety of low cost investment options. Two common ways of titling a brokerage account are as an individual account or Joint Tenants With Rights of Survivorship (JTWROS) where the account is jointly owned by you and your partner and – in the event that one dies – ownership fully transfers in entirety to the other. This type of account can also be titled as a guardian account. While the child’s name is attached to the account it carries no legal ownership and capital gains and tax liabilities are taxed to the parent at their marginal rate (long term, probably 15-20%). Children cannot open their own account until they reach the legal age of majority.

This brings us to the second option: custodial accounts.

Custodial Accounts

Custodial accounts hold the child’s assets. These types of accounts were established by the Uniform Gifts to Minors Act (UGMA) in 1956 and expanded in scope by the Uniform Transfers to Minors Act (UTMA) in 1986 to allow children to own assets before they reach the age of majority. Once the account has been set up, the funds within the account belong to the child but are managed by a custodian who has a fiduciary duty to the minor. A custodian maintains responsibility for making investment decisions before the child enters adulthood. Their role managing the assets continues until the custodianship ends. As a donor, you may designate either yourself or someone else as the custodian. Depending on the account type, and the state in which the account is located, the time at which the account authority passes to the child will probably be between 18 and 25. California allows the transfer to take place as late as 25, if this is outlined when the account is initially set up. Otherwise it happens at the legal age of majority, 18.

A custodial account has trade-offs. On one hand the tax advantages protect the account from the same level of taxation as the child’s parents. Before the child is 18 the first $1,050 of earnings is untaxed, and the next $1,050 is taxed at the child’s rate. Any earnings over $2,100 are taxed at the parent’s rate. This is often referred to as the “kiddie tax.”

This potential for untaxed growth can have real implications. Custodians can harvest earnings for the account’s tax free profit. Let’s look briefly at a hypothetical example. If last year you placed $5,000 in your five-year old child’s custodial account and it grew to $7,000, the custodian could sell the entire holding, reinvest in different securities, and harvest the gain tax free. The following year they could hypothetically (with the market growing cooperating) do the same. Alternatively if the assets were held in your own taxable account and you were subject to 20% long-term capital gains rate you would lose $400 of the realized growth to taxes.

Investment options may also be chosen that don’t spin off significant income, often allowing for tax free growth in custodial accounts. In 2015 the S&P 500 distributed a 2.11% dividend. So, if you had $50,000 invested in an S&P500 index fund, you would have received only $1,055 in dividend payments. In a custodial account, all but the last $5 would be automatically tax free. This $5 would be taxed based on your child’s rate, which might also be $0.

In 2016 the S&P500 delivered a 2.01% dividend, or $1,002, leaving the same account with completely tax free growth.

The tax benefits are balanced by other characteristics of custodial accounts. The finality of ownership provides clarity on who will ultimately use the money. Unlike saving for your child inside your own account, once you or someone else deposits in a custodial account the child will ultimately spend it. They may spend it on their wedding or first house, but they can also choose to spend every penny on a three year vacation in New Zealand.

As I briefly mentioned in Part I of this series, custodial accounts are counted as the child’s asset on the FAFSA, and as such are not ideal savings mechanisms for college savings. Of course, if you have already calculated that your family won’t qualify for need-based aid, and you’ll end up paying for their schooling, an UTMA/UGMA account may be useful for the tax benefits.

Retirement Accounts

After parent owned investment accounts and custodial accounts, retirement accounts are the third option for choosing where to place savings intended for your child.

In recent years saving for children’s college through a Roth IRA has been widely popularized. Some unique characteristics of the Roth account make this an interesting option.

First of all, the Roth provides some spending flexibility. If your child decides against higher education your Roth will be able to fund your retirement, while a Roth owned by the child would fund theirs. This provides greater freedom than an UTMA or UGMA account, but unlike those custodial accounts, the Roth is designed primarily as a retirement account and won’t let your child blow the whole thing on their New Zealand adventure.

Secondly, there is some tax flexibility. In most cases, when someone withdraws funds from a retirement account prior to age 59½ there is a 10% penalty assessed by the IRS on top of any taxes owed. With a Roth account, only the earnings are assessed this penalty. The deposits have already been taxed. Deposits withdrawn for education expenses, including tuition, fees, books and room and board are not taxed when distributed from a Roth, and are not subject to the penalty.

Keep in mind that the excess of deposits, or growth, is still taxed. For this reason earnings should never be withdrawn from a Roth for education. It somewhat defeats the purpose of saving in your Roth bucket if you’re ultimately going to have to pay taxes on the earnings. But if you save $5,000 per year for 20 years you’ll have $100,000 of deposits to withdraw for education, while keeping the growth for your retirement.

As mentioned in Part I, funds in retirement accounts are not used to calculate the expected family contribution on the FAFSA.

While contributing to a Roth account is limited by income and whether your employer offers a retirement plan, there are a couple other ways of working yourself or your child into a Roth IRA, regardless of your income level. You may be able to contribute after tax dollars to a Roth 401k in your employer’s plan. Once you leave this employer you will be able to roll this into a Roth IRA. You may also have a traditional 401k or IRA that you can convert (and pay the deferred taxes) to create a Roth IRA. If you’re curious about how Roth conversions work, check out Michael Kitces’ comprehensive technical article which you can find here.

To contribute a Roth IRA, the owner of the account must have earned income. Before your kid has a job, they can’t save in a Roth. But once they do, every penny they earn up to the annual $5,500 limit can be saved into their own Roth account. While they are minors this would have to be set up as a custodial account, where an adult serves as the custodian until they reach the age of majority. Of course they may not be thrilled about depositing their lawn mowing money into a retirement account. This is where I hope to match my kid’s savings. With every dollar they earn, my wife and I hope to give them the same amount to place in their Roth. I hope this will teach them about the power of saving, compounding, and investing while also giving them a head start on saving for their future.

In all things Roth, it is important to remember this: while you can use money in your Roth IRA either for retirement income or education expenses, it is important to remember that it will not be usable for both. This is a simple concept, but important to take to heart if you have a Roth account you’ve earmarked for your kids college and don’t have adequate retirement savings yourself.

Today we’ve covered some the pros and cons of saving in these various account types. Saving in your own brokerage account gives you the most freedom, but may cost you extra taxes. Saving in a custodial account may provide some tax shelter but has some fast rules that may create their own downside, including limiting college aid eligibility. Saving in a retirement account such as a Roth may limit retirement contributions and spending options, but has some great tax benefits.

What you may have gathered from this discussion is that greater flexibility tends to bring a greater tax burden and greater restrictions on the usage of an account.  Now that we have discussed these options, we will move on to Part III, the 529 account.