My 5 Favorite Ways to Save for a Minor
Today, we're going to go over some of the options available to you when you're considering putting money away for a minor child, whether it's your own kids, maybe your grandchild, niece, nephew, or any young person in your life. There are so many options, we decided to put together this 6-part Series. Today, I'll give you a brief overview of my 5 favorite ways to save for the children in your life. Each week for the next 5 weeks, we'll go in-depth with each product one at a time. Let's get started and take a look at my Five Favorite Ways to save for minors.
#1 Roth IRA
First of all, Roth IRAs are pretty much my favorite savings vehicle for anyone who is eligible. Period. There are so many advantages to a Roth IRA, and the tax advantages greatly outweigh the disadvantages of this program. Here are a few highlights of the pros and cons of a Roth IRA.
Pros:
All Money earned in a Roth is Tax Free - Forever - and this tax-free compound interest is the biggest, baddest warrior for your child's life-long savings goals. Time is the biggest factor in savings, because compounding interest over 70 years is more effective than trying to desperately sock away thousands of dollars in the last 10 years of your employment. So start your kids off early with a Roth of their very own. Even if they can only save a few thousand dollars over their first 18 years and then never touch it again, that can compound to over $150,000 or more by the time your child retires. The numbers get pretty amazing if you start looking at a life-long growth chart. Let's assume for a moment that no Roth is opened before your child's 18th birthday, just for ease of math. If your child can save just $500/month starting at age 18 and never stop contributing, he or she will have contributed a little over $300,000 to the account, but the balance in that account will likely be over $3,000,000 at age 72. Yes, that's the right number of zeros. That's $3 Million Dollars. Check out this compounding calculator I found at Investor.gov https://www.investor.gov/financial-tools-calculators/calculators/compound-interest-calculator. I used average earnings of 6.8% (which is the annualized real return from the stock market over the last 50 years, after adjusting for inflation) with 2% variance. The value of time is the best asset you have for saving money over the long run.
You can pull out the principal anytime (that's the money you have directly contributed), and you don't pay penalty or taxes - use it for college, purchasing a house, anything you want - no penalty or extra taxes to pull out money you contributed.
When your child turns 59 1/2, he or she can withdraw all the money tax free
There are no required distributions, as there are with tax deferred accounts. With tax-deferred accounts, like a 401k, the government wants some of the tax money from that retirement fund, so they're going to make you withdraw a minimum percentage every year starting around age 72. Roth IRAs are tax free, so there's no need to push you to withdraw that money. It's typically the last savings account people draw from at the end of their lives because the other accounts require distributions. That means if there's money left over after you pass, the money in the Roth can be used as inheritance for your children and grandchildren.
Cons:
It must be earned income, so your 4 year old can't reasonably contribute thousands of dollars every year. Sorry.
It can't be allowance money, it has to be for work other than "you're a kid and you should keep your room clean". That stuff doesn't count. But if your child wants to shovel snow, babysit, garden, work for neighbors, help you clean house, above and beyond cleaning up their dishes, that's valid work you can pay them for. (I employ my kids at $20 a month for chores above and beyond the regular, so that's $240 a year that I can put into their Roth. As they get older, they're more capable of earning more money for jobs around the house and the neighborhood). Motley Fool has a great piece on kid salaries as it relates to Roth contributions, and here's a quote from that article, "If you employ them, keep the pay "reasonable". If you're a business owner, you're allowed to hire your child and use their wages to qualify them to fund a Roth IRA. But they need to be a legitimate employee. This means no putting your 3-year-old on the payroll and saying they earned $6,000 for the year as your "assistant." But if you own a store and have your teenager working the cash register, that's allowed -- so long as the wages are "reasonable" in the eyes of the IRS. Overall, they shouldn't be earning more than you'd pay a stranger to do the exact same job." https://www.fool.com/investing/2021/01/06/5-rules-for-opening-a-roth-ira-for-your-kid/?fbclid=IwAR1Y9A32gHYg236W4HS66fMbRNUPbvHGTijLAw2lrRLjMIh4WFmP1JtdOYc
The contribution limits each year are low - only $6,000
If they make too much money, they can't open or contribute to a Roth. I've got a great article from Investopedia.com that has a chart for the income limits of a Roth. https://www.investopedia.com/retirement/ira-contribution-limits/ The upside here is that it's your CHILD's earned income that's limited, not yours.
You don't get a state tax deduction for money that's contributed each year
When you withdraw money, that counts as income for the year, which can hurt financial aid applications for college applicants, and it will also affect their federal tax bracket, so it's important that you and your child work with a qualified financial planner to help you mitigate these tax implications in years you plan to withdraw money from the fund.
Overall, Roth IRAs are a fantastic place to sock money away that you don't want to pull out for a long time to come, or you want to start growing a fund for your child's college education, and if you pull money out for college, the interest that you leave in the fund will continue to compound as they age.
#2 529 College Savings Plan
College Savings Plans are a wonderful vehicle to save for college. They don't have the same contribution limits Roth IRAs have, they have great tax advantages, and you can change the beneficiary if your child doesn't use all of the balance, so the extra money can go to another child or a grandchild. Let's look at the pros and cons of a 529.
Pros:
All Money earned in a 529 is Tax Free - Forever
There are no contribution limits, and the Gift Tax limit can be extended up to 5 times in one deposit ($75,000) - State laws on this vary, so check with your state
There are no age or income limits to open or contribute to a 529.
Anyone can contribute to the 529 account, not just the earner in the case of a Roth - so Granddad and Grandma can give Christmas gifts by depositing money into the 529 and that money can be used for college expenses
Withdrawals are tax free as long as they're used for a qualifying educational expense
You can change the beneficiary so that other children or grandchildren can use the money for education expenses in the future, which can create a generational college fund for your family.
Cons:
You can only use it for qualifying educational expenses without incurring fees
The ways you can invest this money is limited because the fund is administered by each individual state, and the plans may not offer an attractive investment assortment, depending on which plan you choose. For example, some state plans may offer only high-cost funds or a limited selection of investment funds to choose from
Every state's 529 plan is just a little bit different, so it can be hard to know the exact rules of your individual state's plan. This is where your qualified financial advisor comes in. Hire a specialist to make sure your savings are on track and following all the rules. With a financial advisor on your team, you can set it and forget it, and leave the fine print to someone else.
You don't usually get a state tax deduction for contributions made to a 529. But there are exceptions, for instance, Indiana has a pretty generous 529 tax credit.
When your student withdraws money from the 529, that counts as income for the year, which can hurt financial aid applications for college bound students.
If there's money left over, you pay a penalty to get it back for uses other than education
529 Plans provide a perfect location for college savings as long as you aren’t worried about over-funding. A common solution to this is to fund both a 529 and a Roth IRA or a 529 and a UTMA, so that the excess money can be used for any purpose instead of just educational expenses.
#3 UTMA
A UTMA or "Uniform Transfers to Minors Act" is a great "starter package" for your child to gift them money in their early years that they can access when they become a legal adult. Here are some of the pros and cons of a UTMA:
Pros:
Because money placed in a UTMA account is owned by the child, earnings are generally taxed at the child’s – usually lower – tax rate, rather than the parent’s rate. But be careful of the Kiddie Tax, which can push these rates higher depending on the amount owned by the child. Consult a qualified financial advisor to be sure, before you utilize this tax strategy.
There is a Gift-Tax exemption of $15,000/year for contributions made to a UTMA.
Minors can usually receive gifts and avoid tax consequences until they become of legal age for the state, which is typically age 18 or 21
There are no income limits like you'll find in a Roth IRA
Cons:
The recipient's (minor's) assets go up by the amount of the custodial account, which can make him or her less eligible for needs-based college scholarship programs.
The child gains control of all funds at 18 or 21, depending on the state. This can be a problem if the child is not mature enough to handle the money that is being released to their care.
After the child gains control of the funds, you don't have a legal say in how they spend that money. This can present a real risk to your hard earned savings.
Assets in a UTMA are irrevocable. Once you have contributed to it, there's no way to get that money back out if you need it for an emergency. Technically, as the custodian, you can withdraw from the account "for the benefit of the minor", but basic parental obligations, such as food, clothing, shelter and medical care don't count as viable reasons to withdraw money from this account.
A UTMA or UGMA is a wonderful vehicle for parents and grandparents to provide savings for their children and grandchildren. Because there are no limits on the ways this money can be spent, you can instruct your child that this is specifically for them to buy a house, or a car, or a nest egg for when they’re ready to get married and have a family. By educating your child ahead of time what the money is for, you can hopefully keep them from using it irresponsibly when they come of age.
#4 High Yield Savings Account
For highly risk-averse people, a high-yield savings account may be the best savings vehicle to diligently put money away and virtually eliminate any risk of losing any of the money you've contributed. Here are some pros and cons of a High Yield Savings Account.
Pros:
It's stable! You can rely on the interest being pretty consistent, and it's not variable like the stock market, so for those risk averse individuals who like guaranteed growth, a High Yield savings account may be the way to go.
It's Liquid - you can pull the money back out anytime you need it. It's not tied up with tax or penalty implications, and that's really attractive to some people.
The high yield savings accounts available today at 0.40-0.60% are much better than a traditional savings account earning .001%
All monies up to $250,000 are FDIC insured
No hidden fees - The best high yield savings accounts don't have monthly fees or minimum balance fees, so your money stays yours.
Cons:
1. Average yield of 0.50% is much less than the historical stock market yield (adjusted for inflation) of 6.8%
2. Saving for college will be mostly principal and a tiny fraction of growth from interest
3. The amount is variable, so while it's more stable than the stock market, it's still not a guaranteed rate of return like you'll find in a CD or US Treasury Certificate.
4.Many high yield savings accounts are offered through digital platforms, so there isn't a physical bank you can visit to speak to a human. People tend to be less and less worried about this in a digital age, but some folks still like going to the teller window best, so this could a consideration when deciding how to save for your child
High Yield Savings accounts are a great place to put a little extra slush fund in case of emergencies. They don’t earn a lot, but it’s nice to have a liquid bank of money in case your child wants to go to an extra expensive college fund that your 529 didn’t plan for, or for anything life throws at you.
#5 Endowment Life Insurance plans like Gerber Grow Up Plan
Life Insurance policies like the Gerber Grow Up Plan use a hybrid model of a Term Life Insurance Policy with savings program. Here are some pros and cons of an Endowment Life Insurance plan:
Pros:
Based on the money you save into the plan, you're guaranteed a certain payout, called the endowment, when the policy reaches maturity.
The money can be used for any purpose you like, from education and tuition expenses, to living expenses and pretty much anything you need money for.
Some policies will have a "doubling" effect if you reach a benchmark, for instance "when the beneficiary turns 18", or "at the 10th anniversary of making payments", then the policy gets a doubling bump
There is a death benefit in the event that you die before your child reaches age 18 or before the policy's maturity date, and a lot of people like this guarantee that their child will have a policy to pay for their education and/or life expenses in the absence of their parent.
There's a guaranteed return, so it's a great product for risk-averse people. A lump sum payment is guaranteed at time of death or on the date of maturity.
The cash value of the policy isn't counted against your child's financial aid package eligibility.
Cons:
1. Typically a savings plan attached to a life insurance policy will have very low returns. Low risk = low reward, so most of the benefit of this plan comes from the forced savings of paying into it each month.
2. If you don't pay the premiums, you can lose some of the money you've paid into the program, and not be eligible for the rewards and benefits being advertised at the outset.
3. An endowment plan typically has higher premiums than a regular whole life plan
4. The life insurance portion is not usually convertible to a traditional life insurance policy after the date of maturity, and if you find yourself in an older age bracket, you could pay a lot more for premiums on a new plan after this one matures.
An Endowment plan has a lot of perks, and you just have to decide if the fees and restrictions make it a worthwhile use of your savings. We always lobby for some life insurance, and this is a good way to make a hybrid savings vehicle to protect against the worst case scenario.
Conclusion:
There are lots of other ways to save that we didn't cover here - open a simple custodial bank account, look into a Coverdell Education Savings Account (which is similar to a 529), open a UGMA (which is similar to a UTMA), utilize a Health Savings Account, Open a Trust Fund for your child, Get a Term or Life Insurance policy on yourself to ensure your child doesn't carry any financial burdens after your passing. Or you might do a combination of a few different options. There is no one size fits all, so you'll want to consult with a qualified fee-only Financial Advisor who can steer you in the right direction. Likely the answer will be a combination of a few different products to protect you from all sides and give you the best possibility of success.
But at the end of the day, the biggest key to success in any child's savings journey is not to keep money a mystery for them. Share with your child what you're doing to save for their college journey. Tell them that now is the BEST time to save for their retirement. Break it down so they can understand it. We'll be doing many more videos and blogs on good ways to help teach your kids about money, but there's one that I did on Budgeting for a Trip a few weeks ago, it’s called A Dream Without a Plan is Just a Wish, and I’ll link that in the description below.
In the coming weeks, we'll be going in depth with each of the 5 products we reviewed today. Stay tuned for a focused look at Roth IRAs next week!
If this was helpful, I hope you'll reward yourself for YOUR time by making an extra deposit to your retirement account today. $5, $10, $100! Your future self will thank you! And don't forget to tell your kids that you paid yourself to learn more about retirement savings. Showing them that taking time and effort to educate yourself about your finances, no matter how old you are, is just one more step that you can make towards growing financially confident young adults.
Keep saving, and have a great day!