When you hear financial gurus talk about investing, one of the buzzwords you may hear them frequently mention is “compounding.” While it isn’t true for everything they preach, I can confidently say they are correct in stressing the power of compounding. For those unfamiliar, compounding is the concept of taking earnings from investments and reinvesting them in the market. This process allows your investments to grow at a faster rate the longer they remain in the market. Imagine setting aside $100 a month for your child's investment account, starting just after they’re born. By the time they turn 18, this account would have grown significantly, assuming historical returns from the S&P 500. In fact, starting at birth rather than on their 1st birthday would result in an additional $6,712.75, even though you only contributed an extra $1,200 in that first year. This highlights the value of early investing and the compounding effect over time.
Because of the power of compounding, many people choose to open investment accounts as a savings vehicle for their children’s or grandchildren’s future. However, with so many options available, it can be challenging to understand which one is the best fit. To help simplify this decision, here are some key factors to consider when choosing a savings vehicle for your child or grandchild.
The most popular savings vehicle for this purpose is a 529 Plan. A 529 is a tax-advantaged savings plan that is used to pay for qualified educational expenses. These expenses include college tuition, room and board, books, student loans, and even certain K-12 educational expenses, among other things. If the funds are used for nonqualified expenses, they are subject to federal tax and a 10% penalty.
Once a beneficiary is named, the account can still be used for another family member—such as a sibling or cousin—if the account owner decides to change the beneficiary. Additionally, a recent advantage of the 529 Plan is that if a student doesn’t use all the funds for college, up to $35,000 of the remaining balance can be rolled into a Roth IRA for the beneficiary, tax-free and penalty-free. There are many rules governing this conversion, but it provides a beneficial option if funds go unused. This can be helpful if the beneficiary gets a scholarship or decides college is not for them.
Unlike some investment accounts, there is no annual contribution limit to a 529 Plan. There are also no income restrictions for who can fund a 529 Plan. However, the gift tax will be triggered if a person contributes over $18,000 ($36,000 for married couples) per beneficiary annually to a 529. An exception to this is the ‘superfund’ rule, which allows an individual to contribute up to $90,000 in a single year but prohibits further contributions for the next four years. It’s also important to note that most 529 Plans have a maximum savings limit, typically ranging from $200,000 to $500,000, though this is a concern for only a small number of people.
Another important thing to consider is how the use of these funds will affect the amount of financial aid through FAFSA that the beneficiary will receive. A 529 Plan is considered the owner’s asset rather than the beneficiary’s, so if a parent owns the plan, it can only decrease eligible financial aid by a maximum of 5.64% of the account value. However, it's important to note that 529 withdrawals can affect eligibility for the American Opportunity Tax Credit, unlike other accounts discussed later.
While high fees and limited investment options were once common downsides of 529 Plans, these have dramatically improved in recent years. The updated Michigan Education Savings Plan (MESP), for example, now offers competitive fees and a broader range of investment options, making it a great choice for maximizing potential gains within a 529 Plan.
Another option that is growing in popularity is UGMA (Uniform Gifts to Minors Act) and UTMA (Uniform Transfers to Minors Act) accounts. UGMA and UTMA accounts are custodial accounts where only a minor can be named as the beneficiary of the account. These accounts are essentially the same, with the only difference being that real estate can be included in a UTMA account.
Anyone can contribute to these accounts as there are no income restrictions or contribution limits besides the $18,000 tax-free annual gift limit. When the beneficiary reaches the age of 18 or 21, depending on their state of residence, the custodianship ends, and the account becomes their sole property. In Michigan, this occurs at 21 years old. Since UGMA and UTMA accounts are treated as irrevocable gifts to the child, the beneficiary cannot be changed.
A potential drawback of these accounts is that if the funds are intended for educational expenses, they must be listed on FAFSA as the child’s property. This can limit the amount of financial aid the child receives by up to 20%.
A Coverdell Education Savings Plan (ESA) is another type of Investment account that can be utilized as a savings vehicle for the future of a minor child. A Coverdell ESA is a tax-advantaged account used for educational expenses of children under 18. An advantage to these accounts is that there is a wider range of educational expenses that are considered qualified. However, if the funds are used for nonqualified expenses, they too are subject to federal tax and a 10% penalty.
These accounts have more stringent income requirements for contributions. Contributors can only make the maximum annual contribution of $2,000 if their income is below $95,000 (single) or $190,000 (joint). Those with income between $95,000 and $110,000 (single) or $190,000 and $220,000 (joint), may only make partial contributions. However, if their income exceeds these thresholds, they cannot make any contributions.
Coverdell ESAs can be funded up to the child’s 18th birthday and have to be emptied by the time the beneficiary is 30 years old. Similarly to 529s, Coverdell ESAs allow the beneficiary to be changed to another member of the beneficiary’s family.
Many people prefer Coverdell ESAs because of extremely low fees and the variety of investment options available. These attractive features allow much more flexibility and control on where the money goes and how much it can grow.
Lastly, it is an option to open a Roth IRA on behalf of a minor. Many likely know that Roth IRAs are tax-advantaged retirement accounts where there is no tax deduction up front but once the money is contributed to the account, the growth and withdrawals are tax-free.
Minor Roth IRAs can be opened for a child only if they have earned income, which is defined as money derived from paid work. This caveat limits the amount of minors who are eligible for a Roth IRA.
The contribution limit for a Roth IRA is $7,000 for most individuals, excluding extremely high earners who are allowed to contribute either a reduced amount or none at all depending on their adjusted gross income.
With this type of account, contributions can always be withdrawn without tax and penalty but the earnings cannot be withdrawn until the owner has held the Roth IRA for 5 years and they are at least 59 ½ years old. The only exceptions to this are if the funds are being used for certain qualified educational expenses or if you are withdrawing up to $10,000 to build or purchase a home.
Which One is “The Best?”
The answer to this question fully depends on your specific goals and situation. Each of these savings vehicles has distinct pros and cons that depend on multiple factors. If you are looking to save for a child or grandchild of yours, reach out to us and we will help you decide what the best option is for you!