Joint brokerage account. Custodial Account. 529. Coverdell Education Savings Account. Roth IRA… Are your eyes glazed over yet?
There are so many investment account types. How do you know which one(s) to open for your child?
My answer? Well, it’s complicated. The answer for you and your situation might be very different than the answer for your neighbor. Nonetheless, I will demonstrate situations where you might consider certain types of investment accounts for your child!
529 – Great for college bound families
A 529 is my preferred method of saving for college. I won’t go into depth here, but if you want to know, I wrote an entire blog about why I love 529s HERE.
Anyone who wishes may contribute to the account – aunts, grandparents, friends, etc. While there are special lump sum rules, an individual can generally contribute $15,000 each year.
Something to consider about a 529 is that it can reduce the amount of financial aid a student will receive when going to college. However, this is often less significant than owning other investment accounts because 529 funds do not count as income when determining aid.
For many people, a 529 is an integral piece of a college savings plan. Note: you can use multiple account types!
Roth IRAs – Useful for college bound families who need a bit more flexibility
Roth IRAs are designed to be a savings vehicle for retirement. However, there are tax and penalty free withdrawal opportunities for those using Roth IRA funds for higher education expenses.
Only the Roth IRA account owner can contribute to the account IF they have earned income, and the contribution cannot be more than $6,000 per year, or $7,000 for age 50 or older (the IRS often increasing the limits every few years).
The benefit of Roth IRAs over 529s is that there are no investment restrictions, where a 529 plan generally has a set list of options to choose from.
Using funds from a Roth IRA to pay for education expenses can be included as income on a student’s FASFA, which is certainly important to consider.
You might use a Roth IRA to save if you think there is a good chance no one in your family will attend college, you don’t want your contributions to count towards your gift exclusion (generally only applies to the wealthy), or you think you just may need the money for yourself in the end.
My concern: I worry that some bad advisors only recommend Roth IRAs because they can’t manage and bill you on 529 accounts.
If you are debating solely between a 529 and Roth IRA for college savings, I suggest you read Investopedia’s simple article HERE. They compare the accounts quite well.
Joint Investment Account – An excellent account for people who just don’t want any restrictions!
Just like you can open a joint savings account with your child, you can also open a joint investment account. That means you each have EQUAL control over the account. If you are worried about an exuberant teenager draining the funds, you can also set up rules requiring both signatures before money can leave the account.
Generally, only the parent would file a tax return to report the interest or capital gains income. Remember, these are taxable, non-retirement accounts. You pay taxes on the earnings every year.
You can spend the money in this account whenever and on whatever you want. It can be used for a car, home, college, etc.
Custodial Accounts (UGMAs or UTMAs) – A classic way of gifting funds for flexible use in the future
Custodial accounts can also provide a lot of flexibility on what the money can eventually be used for. The kicker is, once a parent puts money in the account, the money no longer really belongs to the parents. The child can’t spend it without the parents’ permission, but the parent can’t just “take it back.”
Custodial accounts also carry some different tax consequences. Income earned is taxed annually, just like the joint investment account. However, this money is taxable to the child. Thankfully, your child can have up to $2,200 of unearned income before it is subject to tax. For some families, the prospect of filing an additional tax return is daunting. For others… the idea of getting $2,200 of income tax free is appealing.
The IRS explains the topic pretty clearly HERE.
Note: the only notable difference between Uniform Transfers to Minors Act (UTMA) and Uniform Gift to Minors Act (UGMA) accounts is that UGMAs can only include cash, tradable securities and insurance policies where UTMAs can also hold real assets like art, property, or intellectual property.
Coverdell Educations Saving Accounts – A dying but still useful method of saving for college
By the name of the account, you can tell this is another way to save for college. I won’t talk about it at length as it is becoming a more outdated way of saving.
You can only contribute to this account until the beneficiary turns 18 and it must be used by the time they are 30. You can only contribute up to $2,000 per year per beneficiary, so there are some limitations there.
You may choose any investment (unlike the 529 plan). The contributions are not tax deductible, but they do grow tax free like the 529 and Roth IRA.
I want to put a big disclaimer out there that there is SO MUCH MORE TO KNOW ABOUT EACH OF THESE ACCOUNT TYPES! Truly, each account type is deserving of their own blog post. I intended only to introduce you to these accounts for future consideration. Talking to a financial advisor or CPA would be a wonderful place to start if you are considering opening an account for your child.