Kids Savings Accounts

“How should we save for our kids’ future?”  A simple question that somehow got real complicated, real fast.  

This weeks #FridayFights blog was sparked from a recent conversation we had with a couple that has two children under the age of 3. The couple shared a common goal: they wanted to set money aside for each of their daughters’ future.  However, one wanted it to be specifically utilized for higher education and the other did not want to limit how the funds can be utilized.   

This conflict is not unique to them.  We find that most of the couples we work with want to save for their child’s future.  They’re just not quite sure how.  I don’t blame them.  There are multiple options to consider, and each one has reasons why you should or should not utilize it.  For the couple we were working with, we went through the various options available to them (three of which are described below).  We then helped guide them through what savings tool works best for their intentions. Through education, asking the right questions, and providing a platform for this discussion, they were able to decide what works best for them.  And as you know, whenever we have a positive experience with one couple, we want to share it with all of you!

So to help guide you with your decision, we break down three common savings vehicles (bank accounts, custodial accounts, and 529 plans) and look at how they work, tax considerations for each, college aid impact, and control.  Please note: there are more options available than what we list below.  

BANK ACCOUNTS

Description:

Easy peasy.  Start with your current bank to see if they offer a youth account.  Your name will have to be on the account since a minor cannot legally sign documents for this type of venture. In our hometown of Rochester, MN, First Alliance Credit Union and Altra Federal Credit Union have specific options to establish a child's account.

Tax Ramifications:

We now enter the world of Kiddie Tax.  Generally, the first $1,100 of unearned income (interest, gains, and dividends) for the 2019 tax year is untaxed.  This would likely not be the case if that unearned income was in the name of the parents. The next $1,100 would be taxed at 10%, and it QUICKLY goes up from there since the kiddie tax now uses the same tax rates as trusts and estates (which are not so nice tax rates).  Now remember, savings accounts still average no more than 2% interest.  Therefore, for you to have more than $1,100 of interest in a savings account, the total account value would need to be at least $55,000.

***UPDATE AS OF 12/30/2019***
Congress recently passed the SECURE Act and therefore the Kiddie Tax rules revert back to parents’ marginal tax rates. However, taxpayers can actually elect to apply the previous Kiddie Tax rules (using trust tax rates) to the current 2019 AND 2018 tax year.

College Aid Impact:

Long story short: accounts owned in the child’s name, like a savings or brokerage account, can count nearly four times greater towards their ‘Expected Family Contribution.’  A student’s expected family contribution (EFC) is between 20-25% while their parents assets are calculated just above 5.6%.  For example, if you had $10,000 saved for your child, the school would expect you to contribute $2,000 of those funds (if it was a child owned asset) as opposed to $560 (if it was a parent owned asset).  Wowzers.

Control:

The funds can be utilized for anything.  Since the parent would be a joint owner on the account, that also means the parent has flexibility to utilize the funds for purposes other than that specific child.  Typically, when the child turns 18, the parent has to sign a form to remove themselves from the account.  This flexibility is the biggest advantage with bank accounts.  

CUSTODIAL ACCOUNTS

Description:

These accounts would be utilized if you want to expand your savings options above and beyond cash bearing accounts to investments like stocks, bonds, mutual funds, real estate, intellectual property, etc.

Contributions to a Custodial Account are irrevocable.  Once they are in the account, you can only use the funds for the benefit of the child.  If your car breaks down, your house needs a new roof, or another child needs additional resources, this account cannot be utilized for such things.

Tax Ramifications:

Same as a bank account!  However, because you may experience greater returns, your unearned income can accumulate faster and greater than what would have happened in a savings account.  This is when you will want to pay particular attention to the Kiddie Tax Rules.

College Aid Impact:

These accounts are also considered student/child owned accounts.  Therefore, they will be treated similarly to bank accounts in that the Expected Family Contribution is greater for assets that are held in the child’s name.

Control:

These accounts are owned by the child, but the parent maintains control over the investment decisions, contributions, and withdrawals until the child reaches the age of majority.  Once the child reaches that age (each state is different), the child now has full control over the assets.

529 PLANS

Description:

A 529 plan is an account specifically designed to encourage saving for future educational expenses.  There are two types to choose from; a prepaid tuition plan and an education savings plan. The prepaid tuition plan allows the account owner to purchase credits for selective colleges and universities for tuition and mandatory fees.  An education savings plan allows the account owner to open an investment account to save for tuition, mandatory fees, AND room and board. Education savings plans can also be used to pay up to $10,000 per year per beneficiary for tuition at any public, private or religious elementary or secondary school.

Tax Ramifications:

Withdrawals from a 529 plan are not subject to federal taxation, and most in cases, state taxation if the expenses are used for qualifying educational expenses.  You may also have specific state advantages for contributing towards a 529 Plan. For instance, in the state of MN, you may be eligible for a $500 tax credit or a $3,000 deduction for joint filers.  Check here to see your state’s deduction or credit for 529 plan contributions.

College Aid Impact:

On the FAFSA (Free Application for Federal Student Aid) form, a 529 plan owned by the custodial parent(s) typically count as an investment and it may reduce need-based aid by a maximum of 5.64% of the asset’s value.  If you recall from up above, a custodial account can can reduce financial aid by 20%.  

Control:

The owner of the 529 plan maintains control over the account at all times, even when the child is in school and/or graduated!  The owner also has the ability to change the beneficiary (or child) of the account at any time.  

It’s important to highlight that with a 529 plan, you are limited to how the dollars can be utilized.  If you wanted to the funds to potentially be used for things outside of education (retirement, first home, wedding, traveling, etc.) this account would not be appropriate because of the penalty assessed on distributions that are not used for qualified educational expenses.

WHAT OPTION IS BEST FOR YOU

The answer may be one or a combination of all three!  I’m a big fan of options and flexibility, because you just never know what the future holds.  To help guide the two of you with your decision, start with the following questions:

1. Why is this important to you?

2. How will this decision impact your children in the long run?

3. What are the possibilities you want to provide to your children by this decision?

Once you and your partner have an idea on the purpose, impact, and goals for funding your child’s future, ask yourself these simple YES or NO questions to help find the right savings tool for you:  

1. Do you want the funds to be solely be utilized for educational expenses?

   • If yes, all three options work

   • If no, eliminate the 529 Plan

2. Do you want to invest in options above and beyond cash?

   • If yes, eliminate the Bank Account

   • If no, all three options work

3. Do you want to maintain control over the account indefinitely?

   • If yes, eliminate the UTMA/UGMA account

   • If no, eliminate the 529 plan and Bank account.