Savings to Set Up for a Child or Grandchild

In life's journey, we often dream of a brighter future for our loved ones, especially our children and grandchildren. As you spend time with your little ones, questions about their future may arise. Will they go to school, or will they enter the workforce? Will they join the military? How can I help them succeed, no matter where they go?

How do you know what is the best college savings account? There are many investment options available that can help you save for children and grandchildren. Some focus on college savings, others on retirement, and some help to prepare for purchases in their adult life. Some options have benefits not only for them but for you as well. Below, we outline the different types of investment options and some of their features. We briefly review ways to invest in these accounts through gifting. We also discuss opportunities on how to invest in their future through financial literacy starting at an early age.

What College Savings Accounts Should You Choose?

Your children or grandchildren may be too young to think about college now. Still, before you know it, they’ll decide which one they go to, from the local college a couple of miles away to the other side of the country. The costs may surprise you even at local colleges, and education costs continue to rise. Completing the FAFSA may provide loan options, and colleges may offer scholarships of various sizes. Even after those options are exhausted, you may still find yourself with a college bill. There are a couple of different accounts to choose from when saving for college.

Consider Investing in a 529 Plan

Who can open a 529 account? 529 accounts offer parents, grandparents, and other family members with no dependents opportunities to save money for their loved ones while allowing it to be invested in the market. Compared to UTMAs and UGMAs that we will visit below, these accounts stay in the grantor’s name, meaning that the beneficiary will not gain ownership unless specifically given after turning 18. Parents, grandparents, or those who own the 529 may reclaim unused funds. There are two types of 529 plans: prepaid tuition and college savings.

Prepaid Tuition 529 Plans

Prepaid Tuition Plans save money toward certain schools and programs within a specific state. This account is usually restricted to tuition and mandatory fees and may not help with room and board. It may also be limited to undergraduate studies only and what can be used for out-of-state college costs. The investment return tracks tuition inflation and may be for someone who is more risk averse.

College Savings 529 Plans

College savings 529 plans are broader and tied to the market. This option might be for someone willing to take on more risk to access market returns. Most schools, including out-of-state institutions, may qualify to receive 529 funds. The advantage of a 529 savings plan is that this type of 529 plan covers a broader range of college expenses. These may include tuition, room and board, miscellaneous fees, and items for college, such as a laptop or books. You can also utilize this money towards graduate studies (depending on the program). 

It's important to note that these accounts are generally considered a parent's/grandparent's asset for the FAFSA application. This may negatively affect the child’s Student Aid Index for financial aid.

Can You Refund a 529 College Savings Plan?

What if your child or grandchild decides not to go to college? Or what if they did go to college and had scholarships to the point where you have excess funds left in the 529? These are some instances where a 529 scholarship refund may be necessary. For a prepaid tuition plan, refunds are the investments plus a low rate of interest.  For a college savings plan, you can either pull the money out and pay taxes on any gains plus a 10% penalty or change the beneficiary to another child or grandchild. This offers an alternative way to invest in other family members as well. You may be able to use the funds for yourself if you decide to return to school.

529 plans are now available for kindergarten through 12th grade tuition costs up to $10,000 per year. Some plans may allow distributions to pay student loans up to a limit of $10,000 in a lifetime for any person. Also, under SECURE Act 2.0, starting in 2024, 529s with excess money after college may be rolled into a Roth IRA. Annual limits apply ($7,000 in 2024) and have a lifetime limit of $35,000.

Coverdell Education Savings Plans (ESA)

Individuals can contribute to Coverdell Education Savings plans (ESAs) up to $2,000/year for each child under 18. Coverdell ESAs are trust accounts established by the U.S. government to assist families in funding educational expenses for beneficiaries. These accounts are similar to a 529 plan, but funds may also be used for other education expenses for elementary and secondary school. Contributions can be used for kindergarten through 12th grade and for college expenses. There are contribution limits that phase out for higher-income earners. The money from these accounts must be distributed to the beneficiary at the age of 30. It’s important to be aware of the Coverdell savings account rules. Contributions are not tax deductible, and unlike a 529, there are limits to how much you can contribute per tax year.

Support the Next Generation’s Retirement with Individual Retirement Accounts (IRAs or Roth IRAs)

Adults may have opportunities to help children invest in other ways, such as retirement. Teenagers may begin jobs in high school to help with costs or save up for a specific goal. Adults can open traditional IRAs or Roth IRAs for minors to help them start saving for retirement. Minors can contribute the greater of their income or $7,000 (2024) to these accounts. Family members can help children by contributing to these types of accounts as well to maximize their retirement potential.

TIP: Offer to match your child or grandchild’s contribution into a Roth IRA to encourage them to save.

Gift Funds Using UTMAs and UGMAs

Uniform Transfer to Minors Act (UTMA) and Uniform Gift to Minors Act (UGMA) accounts are custodial taxable accounts that allow assets to be held for children. UGMAs can be invested in cash-type investments, such as Patriot bonds (also known as EE bonds), stocks, mutual funds, CDs, savings accounts, etc. UTMAs can be invested in those listed for UGMAs, as well as real estate and/or limited partnerships. Parents, grandparents, and others can gift money to these accounts. Assets held in UGMAs/UTMAs are considered assets for the child. Depending on the state, these accounts can be transferred to a 529, but both the beneficiary and the beneficial owner must stay the same.

UGMAs are transferred to the child at the age of majority (age 18 or 21, depending on the state), and UTMAs can be held by the custodian until the child reaches age 25. Once the assets are transferred to the child into an individual taxable account, the assets are theirs, and they can use the money however they wish. The custodian loses the right to specify what the funds may be used for. They may use it to purchase a new car, a down payment on a home, education costs, or anything they wish to purchase or invest in.

TIP: Encourage your children to review investment options with you and learn about the stock market through this account.

Be careful with your investments in these accounts. These are still considered taxable accounts, and gains or dividends may be taxable to the child. Kiddie tax may apply to children under 18. The first $1,300 in gains/dividends are exempt from tax, the next $1,300 is taxed at the child's tax rate, and anything over $2,600 is taxed at the parent's tax rate. It's important to discuss with your financial advisor and accountant how these accounts may affect your child's taxation and how they may affect FAFSA applications when applying for a school.

How to Fund Accounts for your Children and Grandchildren

How do you contribute to a 529 plan? There are various methods to fund these accounts, but most people offer a cash gift to invest. The annual gifting limit in 2024 is $18,000/person/gifter without paying taxes on those gifts. This means a set of grandparents can contribute up to $36,000 per grandchild. For 529’s, you can also provide a one-time contribution of $90,000 for a five-year period (or $180,000 for a couple). You would not be allowed to gift to this child/grandchild for five years, or federal gift taxes would apply.

There are also opportunities to gift stocks into certain accounts. Gifting limits apply to these as well. Including your children in the investment process provides a chance for them to experience how stocks work, and they can watch as their accounts grow.

Gifting may be a great way to provide inheritance while you are still alive rather than waiting until after death. This may help lower your estate value so that your family and friends will not have to pay as much as an inheritance tax later on.

Setting up a 529 plan for a child is best done early. Most of the accounts above can be contributed to monthly, quarterly, or annually. Depending on the account's custodian, you can set up electronic auto purchases or send in checks. Birthdays and holidays are also great times to consider investing in your family's future.

TIP: Instead of buying gifts, consider investing in one of these accounts for very young children or grandchildren. Starting young will also help with compound interest!

You may also want these accounts to be owned (or have a successor owner assigned) by a trust. This will allow the original owner’s wishes to be kept and the money distributed appropriately to the specific child this is for should you pass before they have access to the funds. Discuss utilizing a trust as an ownership option with your financial advisor and estate attorney.

Educate Your Children and Grandchildren How to be Financially Responsible

Teaching children about money and investing is one of the greatest benefits you provide to them. There are many resources today that can help educate children for young children, such as books, TV shows, apps, and board games like Monopoly or The Game of Life. For older children, there are online simulations or educational programs. Some schools or programs have investment clubs where kids learn how to invest and research stocks. You can peruse our blog for more information about ways to educate your child, such as How to Raise Financially Responsible Children and 10 Ways to Teach Your Kids about Finances. As they get older, include children in your budgeting and money discussions or encourage them to join you in a meeting with your financial advisor.

Conclusion

As you continue to review your options to save for a child's future, it's essential to remember that every dollar saved today is an investment in tomorrow's opportunities. Whether you're saving for education, retirement, or any other future goal for your little ones, the right investment vehicle can make a significant difference. There are multiple options to fund these accounts that may not only benefit the younger generation but also yourself as well. By also providing the gift of financial literacy to your children and grandchildren, you may provide them with an even better future simply by educating them, and you can rest assured that you've planned for their security.

Take the first step today by exploring these options with a financial advisor or researching further to determine which strategies align best for your child's future. Contact one of our financial advisors today to learn more.

Author: Ariel Watson, CFP® | Allegheny Financial Group | July 2024

Allegheny Financial Group is a Registered Investment Advisor. Securities offered through Allegheny Investments, LTD, a registered broker/dealer. Member FINRA/SIPC.