Having a baby triggers more than joyful moments and sleepless nights. It triggers financial and lifestyle change, which is why it’s a life event that should cause us all to stop, take stock, and act.
There are several investment opportunities available to you to save for your child’s education and financial future. Here’s three to consider after bringing home baby.
College Savings 529 Plans
Available to all, 529 plans are a way to park funds in an interest-bearing account often tied to the age of the child. Growth and income in the accounts are tax free as long as the distributions are made for college and other eligible expenses. Contributions to these plans are deductible at that state level regardless of who makes the contribution under most circumstances if made to the state plan where the donor resides.
The account is invested in a limited offering of mutual funds, or a model portfolio, and is rebalanced every year based on the age of the child. For those accounts tied to the age of the child, investments become more conservative the closer the child gets to college age.
Funds from these accounts can be used to pay for:
- College expenses, including tuition, housing, books, and other
- Tuition associated with K-12 public, private and religious education, as expanded with last year’s federal tax code overhaul (Section 529(c)(7) of the Internal Revenue Code)
Earnings from eligible college and K-12 distributions are fully taxed. Funds may not be removed from the account for expenses outside of eligible education costs without a penalty and tax consequences.
You own the 529 account and the child is the beneficiary. This means the child does not have access to these funds, and it is only by your good graces that the child becomes the beneficiary of these funds.
You can change the beneficiary at any time. Money can easily be transferred among 529 accounts; if one child spends less and another child needs more, you can move funds from one account to the other.
In the event the child doesn’t attend college, the beneficiary of the account can be transferred to another family member. When it’s time to fund that college education, 529 plans have less of an impact on the FAFSA application than other savings vehicles.
Bottom line: Money in the plan must be used by the beneficiary or a family member of the beneficiary for education. If there is any concern about whether the child will attend college, another savings plan should be considered.
Coverdell Education Savings Account Plans
Available to all, Coverdell (ESA) plans are a way to park funds in an investment account that can be managed and invested broadly. Growth and income in the accounts are tax free as long as the distributions are made for college expenses. Funds from these accounts can be used to pay for college expenses, including tuition and books.
Uniform Gift to Minors Act (UTMA)
Unlike 529 accounts, Uniform Gift to Minors Act (UTMA) accounts are owned by the child and have an appointed custodian of the account, often a parent or grandparent. UTMA accounts also have:
- No limitations on contributions.
- Contributions qualifying as “gifts” up to $15,000 (single) or $30,000 (married filing jointly) can be made without incurring federal gift tax.
- UTMA accounts are given higher weight to the FAFSA application making it much more difficult to qualify for financial aid.
While there are no tax benefits to contributors from this type of account, income in the account is taxed at the child’s tax rate, a potentially lower rate than the contributors. The account can be invested without limitation related to investments or strategy, and funds may be used for any purpose as long as it’s for the “benefit of the child.” When the child turns age 21, the custodian is removed from the account and the account is now fully owned by the child.
Bottom line: Money in the UTMA can be used for anything as long as distributions are for the benefit of the child. There is greater portfolio growth potential in this type of account than more limited 529 accounts but UTMA’s provide very little tax benefit to the Individual funding the account.
Managed after-tax account
A more creative option for savings is to invest in an after-tax account geared toward the long term goals of the child. This could include a car purchase, college, wedding, first home or other purchases.
Similar to 529 accounts, the contributor—or individual funding the managed after-tax account—retains ownership of the account, no matter the age of the child. The similarities end there. Gains on this account are taxed according to the account owners tax rate and contributions are a deduction that lowers the accountholders tax liability. And there is no penalty if the funds aren’t used for college expenses.
Tax Tip: Once it is determined that the child will attend a specific college, open a 529 account and use it to run each year’s education costs through to pay for college expenses. The contributor(s) is usually eligible for a state income tax deduction the year the funds are sent through the 529 account (if, for example, contributed to the CO Scholar’s Choice plan for a CO taxpayer).
Which vehicle is right for you?
You can select any or a combination of all these options to set aside savings for your child. Review closely the ownership structure and implications on tax, FAFSA, and other aspects peculiar to the situation before contributing to an account. The Wambolt Team is here to discuss which vehicle is right for you, regardless of the age of your child. Contact us today.