A 529 plan isn't the only way to save for your child's future
Who doesn't love options?
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When a baby comes, financial priorities change. Besides subtracting wine from the budget and adding diapers, you start thinking about the steps you can take now that will pay off later.
At a time when college is expensive, home prices are soaring, and a historic number of people are filing for unemployment, you want to do what you can to make sure your child has a stable future. Assisting with large expenses as they enter adulthood can give them the head start they need to live a financially secure life.
To help you decide where to stash your cash, we talked with a financial expert who gave us the inside scoop on various accounts.
For college savings, look at 529 plans
These state- or institution-sponsored plans help parents cover education costs with two components—prepaid tuition and education savings.
How prepaid tuition works
Prepaid tuition plans are pretty much what they sound like—you prepay for college credits that a student can use when they’re ready to go off to a public or private school.
Plans may guarantee that your prepaid tuition today will cover the cost of college tomorrow even if it increases, so that means you can potentially lock in at a lower price. But it’s important to note that they’re not backed by the federal government, and not all states guarantee them either, meaning you could lose some or all of your investment.
There are a few other drawbacks to consider, including the fact that only about a dozen states like Florida and Maryland are currently accepting new applicants, and you may only be able to redeem credits at certain schools. In addition to meeting certain residency requirements, room and board is often excluded from these plans.
If your child gets a scholarship or doesn’t use the prepaid tuition, you might be able to transfer credits to another family member or request a refund. Make sure to read the rules of your plan before participating so you know what options you have in each scenario.
How education savings works
The second option to consider is the 529 plan education savings account, which affords a bit more flexibility. “I call them the Roth IRA of college planning,” says Melanie Kahrs, certified financial planner and wealth manager at Campbell Wealth Management. That’s because you put in after-tax money, the account grows tax-deferred, and you can pull money out tax-free if you use it for qualified education expenses, much like how the Roth IRA works for retirement.
Depending on the plan you choose, your money gets deposited into an interest-bearing savings account at a bank, or invested in a mutual fund or ETF portfolio. As with prepaid tuition, your investments are not guaranteed by the state or federal government, though you could seek out certain products that are covered by FDIC insurance.
All of this comes with an important piece of fine print: If you withdraw money for anything other than qualifying expenses, you’re usually hit with a 10% tax penalty.
Fortunately, the list of qualifying expenses is pretty broad—you can use the money to cover tuition, room and board, college fees, and education-related expenses like a laptop. You can also use the funds for elementary and secondary education, and sometimes for universities outside of the U.S.
And if your child decides not to go to college, you still have options, according to Kahrs. Here are some scenarios where you can make withdrawals without penalty—though earnings may be subject to taxes:
- If your child decides to go to a trade school: The beneficiary may use funds for an eligible trade school or apprenticeship program.
- If your child enrolls in a military academy: You’re able to take out the cash value of the education they get in the U.S. Military Academy, Naval Academy, Air Force Academy, Coast Guard Academy, or Merchant Marine Academy.
- If your child receives a scholarship: You can take out the amount of the scholarship without a penalty, so there’s still an incentive for your child to work toward a full ride.
- If you want to repay student loan debt: Thanks to the SECURE Act, you can use up to $10,000 to pay off student loans for the beneficiary, and another $10,000 for each of the beneficiary’s siblings as well.
When you’re ready to set up and manage an investment account for education savings, Kahrs recommends working with a financial advisor or choosing an age-based investment option. This is a type of plan where the provider adjusts the asset allocation as your child gets older. Generally, the portfolio gets more conservative as your child gets closer to college age.
You’ll also want to read up other restrictions, fees associated with these accounts, plus tax implications that may affect you.
For monetary gifts, consider custodial accounts
Uniform Transfers to Minors Act (UTMA) and Uniform Gifts to Minors Act (UGMA) accounts are vehicles you can use to give money or property to children, whether they’re your own or not related to you at all. With a custodial account, your child is the beneficiary and you manage the account until they reach between the age of 18 and 25, depending on your state.
These accounts can be set up as savings accounts or investment accounts. Besides gifting money, you can use the UTMA to transfer and manage real estate or other valuable assets for a child.
A custodial investment account specifically can grow exponentially over the course of 10 to 15 years. So, you could use the account to stash away money for their first mortgage, wedding, or even a gap year before college.
Since the account belongs to the child, a portion of earnings may be taxed at their tax rate instead of your own. But this also means you have to turn the money over to them. A child who’s not financially astute could spend it all in a day, says Kahrs. It takes time for children to understand the value of money, and you can help by teaching them financial lessons. But ultimately, you can’t dictate how your child decides to use their gift.
For a bit more control, a brokerage account may be the way to go
If you want to ensure your child doesn’t spend all of a gift in the wrong place, a brokerage account owned by you (or a joint account with your partner) can give you more say in how your child can use a gift. Because the account is in your name, you can control how the money is spent. This could be a brokerage account you might open up at Charles Schwab, Fidelity, or Vanguard.
“The only thing to be aware of in the future is there are gifting rules,” Kahrs says. At the moment, you need to pay the gift tax if you give more than $15,000 individually (or $30,000 as a married couple) in one year to your child. If you plan to give a large sum, you may want to consider gifting smaller amounts annually.
For short-term goals, research CDs and high-yield savings accounts
Say your child is 14 and they’re a few years away from needing a set of wheels. According to Kahrs, anything that you need to purchase within five years—such as a car or musical instrument—can be saved for in a short-term liquid account. That could be a high-yield savings account, money market account, or certificate of deposit (CD).
A CD is a savings vehicle where you put money away for a certain amount of time until it matures. Common terms are six to 24 months or more. You’re typically not able to make regular deposits into the CD; it’s more of a set-and-forget type of savings vehicle.
Some high-yield savings and money market accounts rival the interest rates of CDs, and could be a better option if you want to contribute cash regularly. Compare the annual percentage yields (APYs) offered by banks and credit unions to see where you can get the best return.
Whichever you choose, start early and stay the course
Kahrs stresses the importance of starting early and being consistent. Even small amounts of $25 per month or per paycheck can add up if you’re saving or investing over 10 to 15 years. And you can always increase your contributions as your income increases or when you get a cash bonus. Choose a savings goal and set up an automatic transfer from your checking account so you can stockpile cash without even thinking about it.