Did your child just receive a birthday check? Are you trying to get a head start on saving for your kids’ college costs? Or are you looking to help your kids later in life? There are many different types of accounts available for the benefit of your child. Which one you choose depends on a number of factors, including what you hope to achieve. SageVest Kids considers 529 plans and other savings account options for your child, exploring the pros and cons of college savings plans, custodial accounts, Trusts, and more.
Section 529 College Savings Plans
529 plans are tax-advantaged education savings accounts. They’re one of the most popular ways to save for college and what we often recommend. These accounts have become more flexible, with funding options that extend beyond college. However, they still have limitations.
529 Plan Advantages
- Federal Tax Benefits: Contributions accumulate tax-deferred, and earnings are tax-free if distributed for qualified educational expenses.
- State Tax Benefits: Some states offer tax deduction benefits. Find out more about your state’s offerings here.
- Flexibility: Anyone can open a 529 plan, regardless of income. Furthermore, as account owner, you can change the beneficiary to another qualified family member at any time.
- High Contribution Limits: Many states permit funding up to $350,000.
- Advanced Gifting: Contributions can be accelerated, allowing up to five years of annual giving in one year. In 2019, that means you can contribute up to $75,000 (5 x annual gifting limit of $15,000).
- College Costs: Funds can be used for tuition, fees, room and board, or books at any accredited college or graduate school in the US or abroad.
- K-12 Tuition: Up to $10,000 per year can be withdrawn for K-12 tuition.
- ABLE Transfers: Account owners can roll over funds to an ABLE account to be used for disability-related expenses.
Section 529 Plan Disadvantages
- Usage: Tax-free distributions aren’t permitted for non-educational expenses e.g., camps, activities, and childcare.
- Penalties: If funds aren’t used
for education costs, a 10% penalty applies on the earnings in the account,
unless the beneficiary:
- dies or becomes disabled.
- attends a US Military Academy.
- receives a scholarship.
- receives educational assistance through a qualifying employer program.
- Limited Investments: Most plans offer limited investment options. These are almost always age-based, with investments becoming more conservative as children approach age 18.
A Coverdell education savings account also offers tax-advantaged savings, with greater flexibility than 529 plans, but with distinctly lower contribution limits.
- Federal Tax Benefits: Contributions accumulate on a tax-deferred basis, and earnings are tax-free if used for qualified educational expenses.
- State Tax Benefits: Most states allow tax-free distributions.
- Investment Flexibility: You can choose your investment options.
- More Qualified Expenses: From Kindergarten through college, Coverdell funds can be withdrawn for tuition, fees, room and board, books, equipment, computers, tutoring, uniforms, and transportation.
- Low Contribution Threshold: The low annual contribution limit of $2,000 makes this account impractical, relative to today’s tuition rates.
- Income Limits: To be eligible to contribute, your modified adjusted gross income must be below $110,000 for single filers, or $220,000 for joint filers, in 2019.
- Penalties: A 10% penalty on earnings is imposed if funds are withdrawn for any use other than qualified expenses.
A custodial account is perhaps the most common account type established for the benefit of a child. It’s fairly easy to set up and has many advantages. However, proceed with caution, especially if the account balance may reach a meaningful level by the time your child reaches the age of majority (age 18 or 21, depending on your state).
Custodial Account Advantages
- Flexibility: A custodial account has the greatest level of flexibility in terms of permitted uses for funds. In addition to education costs, you can make withdrawals for any expense that supports your child’s wellbeing. This can include camps, activities, a car, computers, etc.
- Investment Flexibility: Custodial accounts can be established at most financial institutions, and offer broad investment flexibility.
Custodial Account Disadvantages
- No Tax Benefits: A custodial account receives no tax deferral or other tax benefits. Taxable income and capital gains are taxed under special ‘kiddie tax’ rules, which may complicate your tax filing requirements.
- Loss Of Parental Control: Your child automatically becomes the account owner once they’re no longer a minor (as defined by your state of residence, but typically age 18 or 21). This means you’ll no longer have any legal say over the account or its funds.
- Beneficiary Limitations: Funds can only be used for the benefit of the child named on the account.
A Trust can be used for college and other savings for the benefit of your child. Trusts offer flexibility and protection, but they also come with complexity and costs.
Trust Account Advantages
- Flexible Uses: Trusts can be drafted based upon the terms you dictate. This means that monies can be used for any purpose as long as it’s outlined and permitted in the Trust document.
- Flexible Ages: Monies can be made available at any age, or incrementally over sequential ages.
- Trustee Discretion: The Trustee named on the Trust can be granted broad discretion over distributions, providing latitude regarding amounts, ages, and use of funds.
- Asset Protection: If drafted properly, assets can be protected from creditors.
Trust Account Disadvantages
- Legal Expenses: You’ll have to hire an attorney to draft and execute a Trust.
- Administration: There are legal responsibilities in administering a Trust.
- Tax Filings: Annual tax filings are required for a Trust, creating an extra layer of expense. Furthermore, trusts reach the highest tax bracket at a very low income threshold, currently $12,750 in 2019.
SageVest Wealth Management serves families throughout the DC Metro area and beyond, offering counsel to parents, grandparents, and other individuals regarding future savings objectives, funding options, and financial literacy for children, plus broader wealth management services for you and your family. Please contact us to learn more.