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Investment Funads For Children

Investment Funds For Children

If you are a new parent or your kids are young, you’ll want to do one thing right now: Start putting money into a college savings plan. Having a college fund for kids is generally a surefire way to help transition your children to a successful adulthood.

Parents understand the benefit of a college education not only in terms of personal growth but also in earning potential, career opportunities and financial stability.

College costs tend to increase at about two times the rate of inflation each year; a trend that is expected to continue for the foreseeable future. 

If you want to help your child earn their degree and avoid student loan debt, you may be considering starting a college fund on their behalf. It’s a common idea; according to a recent survey, 85% of families used parent income and savings to pay for college, contributing an average of $13,721 per year

Fortunately, there are ways to start a college fund that can help you and your child cover tuition. Here’s what you can do:

Your funding can be modest, and many parents find they can afford $25–$100 from each paycheck, automatically deposited into the college savings plan of their choice. If you get a raise or bonus, that money (or a portion) can also be allocated toward college savings.

To help your money work harder, take advantage of special savings accounts and plans. By utilizing these college funds, you can help your money grow over time.

First, it’s important to choose the investment vehicle that meets your needs. There are several fund types to choose from, all with their own rules and tax consequences. You can even have more than one account, depending on how your finances change over time. Below are some college saving products to consider:

529 plans

This plan’s name comes from an IRS code section specifically allowing adults to save for college in the name of a child. The plan has tax benefits; the investment earnings from the account grow free of federal taxes if used for qualifying college expenses. The person funding the account pays taxes on the money before it’s contributed to the 529 plan. States sponsor 529 plans that may also have tax advantages to state residents. These accounts can be opened to benefit a student who isn’t the donor’s child, and unused funds can be designated for another student at a later time.

You’ve been saving for years in a 529 plan, which lets you fund your child’s college costs tax-free. But what happens if your kid doesn’t go to college? Will you face a steep tax bill? 

Not to worry. Money in a 529 account can be used tax-free for many types of schooling, not just expenses at a four-year college. And there are several ways you can use those savings, even if your child doesn’t pursue any type of higher education.

There’s also no time limit on using the funds. “A 529 never expires,” says Mark Kantrowitz, former publisher of Savingforcollege.com, a website that provides information on 529s and allows you to compare state-sponsored plans. That gives you leeway to decide how to use the money if your child is on a different track.

Can I roll a 529 into a Roth IRA?

Investing in a 529 plan, a type of education savings account offered by state governments, just became a more attractive option thanks to a new federal law. Starting in 2024, Americans can roll over unused 529 funds into a beneficiary’s Roth IRA with no penalty.

Coverdell Education Savings Accounts

The Coverdell educational savings account is a tax-advantaged way to contribute up to $2,000 a year to a child’s account. This account isn’t available to everyone because you need to be under a certain income level to contribute. The advantage is that funds grow free of federal taxes. Sometimes there are state tax advantages.

If the child doesn’t go to college and does not use the money by the time they are 30, the child (beneficiary) will have the amount distributed to them and will be taxed on the amount.

UGMA accounts

The Uniform Gifts to Minors Act is a custodial account, which means that your child or the minor for whom the account is created can own investments such as stocks and mutual funds.

This account gives them the assets but allows the custodian to control them until the minor reaches the age of majority. This is not considered a traditional college fund because the money does not grow tax-free. In addition, it counts against the student and the parent when applying for financial aid for college, thus reducing the amount of financial aid the school can offer your child.

If you’re looking to save money or transfer assets to your kids for a variety of expenses beyond education, a UGMA/UTMA custodial account can make a lot of sense. One thing to watch out for is that a UGMA/UTMA account is tied specifically to one named beneficiary

529 plans have a more favorable tax and financial aid impact and provide the parent with more control. UGMA and UTMA accounts provide more flexibility in how the funds can be used. Overall, most people will find a 529 plan to be a better option.

UGMA/UTMA accounts aren’t limited to education expenses and withdrawals can be used for anything that benefits the beneficiary. Once the age of majority has been reached (18 or 21 in most states), the beneficiary is entitled to the account. There are no contribution limits on UGMA/UTMA accounts.

The first $1,100 in earnings in the UGMA account are tax-free. This earnings figure includes dividends, interest income, and any capital gains. The next $1,100 in earnings is taxable at the child’s tax rate. Because your child probably doesn’t earn much income, their tax rate is typically 10%.

A big drawback is that all assets transferred into an UGMA account law are irrevocable transfers. This means that your child owns the assets, and the child has the authority (not the parent) on how to use the funds once the child reaches the age of majority.

All of the untaxed capital gains in the existing UGMA or UTMA account will be reported as unearned income if converted to a 529 plan. Contributions to a 529 plan must be made in cash, which requires liquidating the UGMA.

You may be able to move money from an UGMA account to a Roth IRA by first selling your UGMA mutual fund, withdrawing the proceeds from the account, contributing it to the Roth account, and purchasing shares of a mutual fund. You can only do this to the extent that the child has taxable income.

Traditional and Roth IRAs

An IRA is a tax-advantaged savings account where you keep investments such as stocks, bonds, and mutual funds. You get to choose the investments in the account and can adjust the investments as your needs and goals change.

Under the SECURE Act, you can now wait until age 72 to begin taking required minimum distributions (RMDs), and the law removed the age requirement for depositing money into a traditional IRA, so you can continue making contributions at any age if you are still working.

 In general, if you withdraw from your IRA before you are 59½ years old, you will owe a 10% additional tax on the early distribution.

However, you can withdraw money from your traditional or Roth IRA before reaching age 59½ without paying the 10% additional tax to pay for qualified higher education expenses for yourself, your spouse, or your children or grandchildren in the year the withdrawal is made. The waiver applies to the 10% penalty only; you will still owe income tax on the distribution unless it’s a Roth IRA.

Drawbacks of this accounts

Using your retirement funds to pay for your child or grandchild’s college tuition does come with a couple of drawbacks:

It takes money out of your retirement fund—money that can’t be put back in (unless you are still working)—so you need to make sure you are well-funded for retirement outside of the IRA.

IRA distributions can be counted as income on the following year’s financial aid application, which can affect eligibility for need-based financial aid.

To avoid dipping into your own retirement, you may be able to set up a Roth IRA in your child’s or grandchild’s name. The catch: Your child (not you) must have earned income from a job during the year for which a contribution is made. You can actually fund their annual contribution, up to the maximum amount, but only if they have earnings.

The IRS doesn’t care where the money comes from as long as it does not exceed the amount your child earned. If your child earns $500 from a summer job, for example, you can make the $500 contribution to the Roth IRA with your own money, and your child can do something else with their earnings. 

Here’s how to do it: If your child is a minor (younger than 18 or 21 years old, depending on the state in which you live), many banks, brokers, and mutual funds will let you set up a custodial or guardian IRA. As the custodian, you (the adult) control the assets in the custodial IRA until your child reaches the age of majority, at which point the assets are turned over to them.

Invest in Mutual Funds

There’s no limit on what you can invest, and of course, the money doesn’t have to go toward college. But what you earn will be subject to annual income taxes, capital gains will be taxed when shares are sold and the mutual fund’s assets can reduce financial aid eligibility.

Take Out a Permanent Life Insurance Policy

This is a college savings plan strategy typically used by high-net-worth families to provide tax-advantaged savings for multiple goals, including higher education, according to Bryan Bentley, a financial advisor with Talon Wealth Management based out of Roseville, California.

A permanent life insurance policy is a conventional life insurance policy, but some of the money from your premium goes into the death benefit, and some of the money goes into a tax-deferred savings account.

One of the pluses of doing this, Bentley says, is that the money you save “can be accessed at any time for any reason, so it is not limited to college expenses. It provides additional benefits such as a death benefit, and other living benefits, and there is no adverse impact if it is not used for education expenses.”

Cash

The annual exclusion allows you to give $16,000 in 2022 (increasing to $17,000 in 2023) in cash or other assets each year to as many people as you want. Spouses can combine annual exclusions to give $32,000 (increasing to $34,000 in 2023) to as many individuals as they like—tax-free.

As a parent or grandparent, you can gift a child up to the annual exclusion each year to help pay for college or other higher education costs. Gifts that exceed the annual exclusion count against the lifetime exemption, which is $12.06 million per individual in 2022 (increasing to $12.92 million in 2023).

Concerned about the lifetime exemption? As a grandparent, you can help your grandchild pay for college while limiting your own tax liability by making a payment directly to their higher-education institution.

As Joanna Foster, MBA, CPA explains, “Grandparents can pay the educational expense directly to the provider, and that does not count against the annual exclusion of $15,000.” So, even if you send $20,000 a year to your grandchild’s college, the amount over $15,000 ($5,000 in this case) would not count against the lifetime exemption.

It’s pretty much common knowledge that the earlier you start saving for a big expense, like college, the better off you’ll be in the long run — and the less likelihood you’ll need to rely on additional financing like student loans.

For parents and guardians who want to help fund their child’s higher education, however, the best place to save that money isn’t necessarily your typical savings or investment account.

How much should going to college saving

How much should you put in your child’s college fund?

Ideally, you should save at least $250 per month if you anticipate your child attending an in-state college (four years, public), $450 per month for an out-of-state public four-year college, and $550 per month for a private non-profit four-year college, from birth to college enrollment.

It’s hard to know exactly how much to save for college for every parent but one-third of a four-year program’s tuition and fees is a good place to start. Using the 1/3 of college education rule, that adds up to $45,120 for a private non-profit, $24,266 for a private for-profit, and $12,533 for a public state college. This might look like $400 or $700 per month, depending on how early you start.

You should also consider inflation in your projections, but a strong 529 plan takes care of that return. Of course, you might want to consider costs for accommodation and residence if your child attends an out-of-state school. In that case, you might tack on an extra $44,000, or a third, which is $14,666. Let’s cover how much you may need to save for college to cover your education. 

Tuition costs increase annually, by at least 6%. The National Center for Education Statistics found a sharp increase between 2010 and 2020 in private nonprofit college tuition, which is a $5,900 jump! Imagine you began a college savings plan in 2010 and saved up to your 2010 tuition goal in 2020. If you could lose nearly $6,000 in value then, you could certainly face the same dilemma ten years from now. 

The solution? Your savings need to increase with inflation, too. That means you need to supplement your original college savings target with an investment model that accommodates inflation. The 529 plan is the best solution, but more on that later. For now, let’s cover some standard college savings amount principles. 

For most families, paying for college is not as simple as writing a check each quarter. Instead, it’s an amalgamation of financial aid, scholarships, grants, and money that the child has earned as well as money that parents and grandparents have contributed to tax-smart college savings vehicles.

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