A friend of mine recently asked me about what type of account to put her kids’ savings into. I thought others might be interested in the topic, too. There are a variety of different types of accounts available with different levels of parental control and implications on college financial aid
The first thing to consider is the purpose of the money and how much is likely to accumulate in the account.
- UTMA Accounts. If the money is really the child’s to spend as they wish and is unlikely to ever be more than a few thousand dollars, then a Uniform Transfers to Minors Act account (UTMA; sometimes known as CUTMA in California) is probably your best bet. This type of account is ideal for saving allowances and gifts from relatives that the child might spend some day. This type of account is available at most banks and is titled in the child’s name with a parent as custodian. The account becomes the child’s asset outright at age 18, so there is a loss of control for the parent. It is also counted as a child asset for college financial aid calculations (20-25% vs. 5% for parent assets), so can be detrimental to financial aid awards. If you are unlikely to qualify for financial aid any way (as many high-earned Bay Area families are not), then an UTMA in the child’s name has the advantage of having the first $2,000 of interest income taxed at the child’s rate.
- 529 Plans. If the money is intended for college and is likely to be a large sum by the time the child enters college, then a college savings account could be appropriate. Of the various college savings vehicles available, I prefer the 529 account due to its large contribution amounts, tax-free growth, flexibility and control. Parents and relatives can contribute up to $14K/per child per year ($28K/couple per child) to a 529 account without filing a gift tax return. You are allowed to do a lump sum contribution equal to five years’ worth of annual contributions (so $140K/couple) and mark an election on the gift tax return so it doesn’t count towards your lifetime maximum gift amount. Money contributed goes in after-tax (some states allow a state income tax deduction on contributions, but California does not), but the money grows tax-free and isn’t taxed when withdrawn as long as the money is used for qualified education expenses. If the money isn’t needed for one child, the parents can change the beneficiary to another child, to a grandchild or even to themselves to use for education expense.
Finally, because it is a parent asset, the child never gains control and it counts as a parent asset for financial aid calculations. I prefer the Utah 529 plan due to low expenses and a good fund line-up managed by Vanguard, a low-cost index fund provider. You can research available plans on www.savingforcollege.com.
- Coverdell Education Savings Accounts (ESAs). These accounts function much like an IRA for education. Their main advantage is that money can be used for K-12 education expenses, not just college ones. However, they have several limitations. The annual contribution limit is $2,000 and if you make more than $220,000 as a couple, you are unable to contribute. The money must be distributed by the time the child is 30. The account counts as a parent asset for financial aid calculations. Contributions go in after-tax, but growth is tax-free if the money is withdrawn for qualified education expenses.
- Roth IRA. If there is uncertainty about college funding (e.g., from a grandparent), then contributing to a 529 or Coverdell account might not be the best choice. If your income allows, you could contribute to a Roth IRA for yourself or the child (if they have earned income), as long as you don’t need those contributions for your own retirement. The initial contributions can be withdrawn without penalty after 5 years and the growth can be withdrawn without paying the 10% penalty prior to 59 ½ if used for qualified education expenses. You can also use a Traditional IRA for college expenses, but the amount withdrawn will be counted as taxable income (assuming contributions were tax deductible). I only advocate this strategy if you won’t need this money for retirement and there is high uncertainty as to other college funding sources. Retirement accounts are excluded from financial aid calculations.
In summary, if the money is really the child’s to spend as they wish and is unlikely to ever be more than a few thousand dollars, then an UTMA account in the child’s name with a parent as custodian is the best bet. Most banks offer these, but you can earn more interest at an online bank, such as CapitalOne 360 or American Express. However, you lose the advantage of taking your child into a real brick and mortar bank. If the money is really intended for college and is likely to accumulate, then a 529 account or perhaps a Roth IRA is most appropriate. Be sure to consult your tax professional to confirm you can contribute to a Roth IRA.