If you’re a parent or grandparent wondering where to put cash gifts for your kids or grandkids, read on!
In this post I’m going to talk about the most common types of accounts used for saving for kids.
529 Plans
When many people think of saving for a child, the first thing that comes to mind is the high cost of their future education. Opening a 529 plan for your child or grandchild is a good strategy to get started.
With a 529 plan, a parent or grandparent is the owner of the account and the child is the beneficiary. This means that the parent or grandparent is always in control of the money.
Distributions from 529 plans are tax-free if they are used for qualified college education expenses. You are also able to save a large amount every year regardless of the taxpayer’s income, allowing you to potentially save enough to cover the total cost of college.
Another nice feature of 529 plans is that they are seen as an asset of the parent for college financial aid purposes. This means they will have less of an effect on financial aid than if the child has money in his or her name in a savings account.
The downside is that distributions above what was originally contributed can become taxable with a 10% penalty if not used for qualified educational expenses. 529 plans are flexible though, so if one child does not go to college or doesn’t use the account, it can be transferred to another beneficiary.
If you’re confused about which 529 plan to choose, check with your own state plan first. Some states offer tax deductions for contributions. Otherwise, you are free to use any state’s 529 plan, and each state’s plan differs considerably on available investment options and fees.
[Check Out: The Best Low Cost 529 Plans for California Residents]
Coverdell Education Savings Account
Coverdell accounts are much less popular than 529 plans for several reasons. The primary disadvantage of opening a Coverdell is the low contribution limit of $2,000/year. Even if you contribute the maximum every year, it’s just not going to be enough to cover most education expenses. Another reason is that taxpayers with high income are restricted from making contributions.
The big advantage over 529s however, is that Coverdells can be used for education expenses for K-12 education, not just college. Since Coverdells are IRA based, they’re also eligible to invest in any investment that an IRA can, so you are not restricted to the limited fund options available in 529 plans.
Just like 529s, distributions are given preferential treatment in financial aid calculations.
If you try to open a Coverdell account, you will find that not all companies offer them. Vanguard is an example of a well-known company that no longer allows new Coverdell accounts. A good alternative is TD Ameritrade where you can invest in many Vanguard index ETFs without trading fees.
UGMA & UTMA Custodial Accounts
The so-called UGMA and UTMA accounts are just taxable brokerage accounts with a parent or other relative serving as the custodian. The important difference is that the child is the owner and you are making an irrevocable gift to the child when making a deposit.
At age 18 (age varies depending on the state) they can use the money for whatever they want, they don’t have to use it for education.
Just like a plain old savings account, these accounts have no tax deferral feature. The income and capital gains will be subject to the kiddie tax rules and your child may need to file a tax return every year.
These accounts also have a big negative effect on financial aid since they are considered an asset of the child, so it’s best to avoid them if you think that there is any chance that your family may qualify for financial aid.
Life Insurance
Do you need life insurance for a baby? The quick answer is NO. Although often promoted as a savings vehicle, whole life insurance is very expensive and is a very bad way to invest for a child. There is almost no reason to purchase life insurance for a baby.
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