As parents and grandparents, we want to give the children in our lives every possible opportunity to succeed and live a fulfilling life. For many people, that means by way of monetary support – whether for college education, the down payment on a first home, wedding, etc. There are a number of ways to save for your child’s future but below I will share 3 of the most common ways I’ve seen over the course of my professional career along with some of the pros and cons of each.

But first, let’s go over a few of the tax rules…

IRS Gifting Limits

Something that I am not sure many people are aware of is that you are not able to pass thousands or millions of dollars on to another person at your discretion without notifying the IRS.

There is a gift tax imposed on the transfer of ownership of property that coincides with the gifting limits. This often only impacts high net worth individuals, but still good information to know and understand.

The IRS has annual and lifetime gifting limits for each individual.

• Annual Exclusion Gift Limits: (For 2023) An individual is able to gift $17,000 annually to anyone they wish without having to file a gift tax return or counting towards their lifetime gift exemption.
  • If you gift more than the annual exclusion amount, you are required to file a gift tax return. Assuming you are under the lifetime gift tax exemption, the gift tax return will be for informational purposes only and you will not owe any tax.
    

• Lifetime Gift Tax Exemption: (For 2023) Over the course of your lifetime, you are able to gift up to $12.92M without owing any gift tax.
  • Anything over and above the lifetime gift tax exemption will be taxed at a rate of anywhere between 18% – 40%. Paid by the donor of the gift.
    
    

Top 3 Ways to Save for Your Child’s Future

Now that you understand your annual and lifetime gifting restrictions, there are a few different ways that you can save for your child’s future. Each serve a different purpose, have different tax structures and benefits and have different elements of control.

So, let’s break it down to determine what is going to align most with your goals around wanting to save for your child’s future.

1. 529 College Savings Plans

A 529 College Savings Plan is a tax advantaged investment account that’s sole purpose is to pay for higher education costs. Almost every state in the country offers their own 529 College Savings Plans for their residents. Find out more about your resident states 529 Plan at SavingforCollege.com

Things to Consider in Funding a 529 Account:

• Opening An Account
  • It is very easy to open an account as each of the 529 State Plans have their own dedicated websites and platforms to open accounts, contribute to accounts, etc.
  • You are able to open an account in any state you wish. You are not required to open a 529 account in the state in which you reside. However, something to consider is that you often get a tax benefit by opening and contributing to your resident state 529.
  • Take a look at your options – fees, state tax deductions or credits, past performance and decide which option makes sense for you.

• Contributions & Withdrawals
  • Anyone can contribute into an individuals 529 Account
  • Your contributions are limited to the extent of the annual gifting exclusion (assuming you don’t want to file a gift tax return) OR a lump sum gift of up to 5 years’ worth of annual gifts, making the 5 year election.
  • Withdrawals are taken out tax FREE so long as they are used for qualified education expenses (such as college tuition & fees, room & board, books & supplies, etc.). If withdrawals are not used for qualified education expenses, you may trigger a 10% penalty and will be taxed on the earnings.

• Taxes
  • Tax Free Growth & Withdrawals. All of your future earnings within the account grow tax free and future withdrawals are tax free SO LONG as the withdrawals are used for qualified education expenses.
  • In State Tax Benefits. If you are a resident of a state and you open and contribute to that particular states 529 College Savings Plan, many (but not all) states will provide you with either a state tax credit or deduction on your state tax return. Each state credit or deduction is different.

• Ownership
  • The owner of the account will remain in control. The beneficiary or student has no legal rights to the 529 account and will not have access to take out withdrawals or make investment decisions at any point.
  • As the owner of the account, you can change the beneficiary of the 529 plan to another family member or sibling of the beneficiary to continue to let the funds within the account grow tax free and later be used for their education.

• Investments & Fees
  • Investment options tend to be more limited and you do not have access to invest in whatever it is that you want. There is typically a specified list of investments to choose from.
  • State sponsored 529 College Savings Plans fees range anywhere from 0.25% to 1.5%. This will be an important number to know before agreeing to open an account in any one particular state.
    
    

If your goal is specifically to fund education for your children, a 529 plan is by far the best option available to you. If you aren’t sure how to start or have more questions on this, then tune in to my blog post all about 529 College Savings Plans.

2. Custodial Investment Account – UTMA

A UTMA account is a custodial account that is opened typically (but not limited to) by a parent or guardian. The parent or guardian is named the custodian on the account and is responsible for managing the assets in the account for the minor child until the child reaches age of majority – typically 18 or 21, depending on the state.

Things to Consider in Funding a UTMA Account:

• Opening An Account
  • Anyone can open an account and/or contribute to a minors UTMA account – grandparents, parents, friends, etc.
  • You are able to open a UTMA Savings Account at most, if not all, banks to save cash
  • You are able to open an UTMA Investment Account at most, if not all, brokerage firms (like Vanguard, Fidelity, Charles Schwab, etc. ) to invest.

• Contributions & Withdrawals
  • There are no limits on contributions into a UTMA account (aside from taking into consideration the annual gift tax limits)
  • Withdrawals before the child reaches age of majority should be limited. The custodian has discretion over how the funds are used in the account for the benefit of the child. They can be used for supplemental support for children like private school costs, extracurricular activities, etc.
  • Withdrawals after the child reaches age of majority have no limitations. There are no restrictions on how the child (now adult) uses the funds that they are now in control of.

• Ownership
  • The custodian is not the real “owner” of the account or funds within it. The minor is. The custodian is holding the assets and acting as a fiduciary of the account and in the best interests of the minor until the minor reaches age of majority and is able to legally control the account on their own.
  • Gifts into a UTMA account are irrevocable, meaning they cannot be reversed.
  • You are not able to transfer assets from one child’s UTMA to another.

• Taxes
  • There will be tax reporting necessary for any income earned in the UTMA account.
  • The minor may be responsible for filing their own tax return if their investment income is greater than $1,150. A parent can elect to claim the child’s unearned income on the parent’s return if certain criteria are met.
  • In 2023, the Kiddie Tax breaks down as follows:
    • The first $1,150 of unearned income is covered by the kiddie tax’s standard deduction, so it isn’t taxed.
    • The next $1,150 is taxed at the child’s, typically lower than parent’s, tax rate.
    • Anything above $2,300 is taxed at the parents’ tax rate.

• Investments & Fees
  • Treated as a typical investment account with a wide range of investments available to invest in.
  • Fees depend on who is managing the account. If you opened up a UTMA account with a financial advisor to manage – you will be paying for the advisor fee along with the fees associated with the investments. If you choose to invest yourself, you will not be paying a management fee and thus will likely save a significant amount on fees moving forward.
    
    

A UTMA account is a great account to consider as you save for your child’s future. It provides more flexibility for the child in the future, and it can be a great opportunity for parents to use this account to educate their children around money, saving and investing.

One of the biggest concerns for guardians is the idea that there may be “too much” in the account for the child once they reach age of majority. Do I really want my 18 year old or 21 year old to have $10,000 or $100,000 or $1,000,000 to their name?

I personally, have never seen any of my young adult clients abuse or disrespect the accounts of which their parents had saved for them. Often times the account was invested and it then became a platform for educating them on investing – what to invest in and why – and motivated them to continue investing at a young age.

But as a parent, I can understand the concern as UTMA’s cannot be “undone” and perhaps there are other personal issues that would impact the child’s ability to appropriately manage the funds.

Depending on your relationship with your child when they reach age of majority and when the ownership of the account switches over to your child, you do have some options available to you to remain abreast of the account and the activity within it. You could utilize your options of shifting the accounts to joint accounts or trusts – so long as your child approves of and agrees to the terms of your involvement. Because after all, the account is legally theirs now.

3. Custodial Roth IRA

A custodial Roth IRA account is a tax advantaged custodial account that is opened typically (but not limited to) by a parent or guardian for the purpose of long-term investing for their child. The parent or guardian is named the custodian on the account and is responsible for managing the assets in the account for the minor child until the child reaches age of majority – typically 18 or 21, depending on the state.

Things to Consider in Funding the Custodial Roth IRA Account:

• Opening an Account
  • You are able to open a Custodial Roth IRA for the benefit of your child. Not all brokerage firms offer this check out Vanguard, Fidelity and Charles Schwab if your existing brokerage firm doesn’t offer it.

• Contributions & Withdrawals
  • Contributions into a child’s Roth IRA have to be in accordance with the Roth IRA income and contribution limits. Please refer to my blog post that discusses everything you need to know about the Roth IRA.
  • The child MUST have earned income in order for contributions to be made into their Roth IRA account.
  • Maximum annual contributions of $6,500 per year, or $7,500 if age 50+ (as of 2023).
  • Withdrawals are in accordance with the Roth limitations. You are able to withdraw funds after age 59 1/2 penalty & tax free – if prior to that, you may trigger a 10% penalty and/or be responsible for paying tax on your earnings.
  • **NOTE: Contributions made into the Roth IRA may be taken out at any time, but the earnings have limitations on your ability to withdraw. I like to keep this as a side note because the point of the Roth is to grow tax free for years and years so…try not to take this money out. But if you have to, you can.**

• Ownership
  • The custodian is not the real owner of the account. The minor is. The custodian is holding the assets and acting as a fiduciary of the account and in the best interests of the minor until the minor reaches age of majority and is able to legally control the account on their own.
  • Contributions and gift made into a Custodial Roth IRA account are irrevocable, meaning they cannot be reversed.

• Taxes
  • Tax free growth and tax free withdrawals so long as the owner of the account waits until age 59 1/2 to take withdrawals of growth. Refer to my Roth IRA blog post for additional specifics.

• Investments & Fees
  • Treated as a typical investment account with a wide range of investments available to invest in.
  • Fees depend on who is managing the account. If you opened up a Roth IRA account with a financial advisor to manage – you will be paying for the advisor fee along with the fees associated with the investments. If you choose to invest yourself, you will not be paying a management fee and will likely be paying significantly less.
    
    

So Which One Do You Choose?

It’s likely that all three of these may make sense for your child at some point throughout their childhood. They serve different purposes for your children and your ability to contribute may shift at different points in their lives which would make one option more appropriate than the other.

In my opinion, The 529 College Savings Plan will be the best option for saving for college and you will benefit most by investing here sooner rather than later to take advantage of tax-free growth. The UTMA will be one of the best ways to provide your kids flexibility of funds and educate your kids on investing and empower them to learn about money, investing, and it’s future impact.

The Custodial Roth IRA is probably my favorite way to save for your child’s future but the biggest constraint here is that the child needs Earned income. Take a look at my blog post on contributing to a Child’s Custodial Roth!

Educate yourself on the different options here as I know there is lots of information to consume. But I hope you found it helpful in understanding what your options are and what may be best for you and your family going forward depending on your personal financial goals!

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