With cost of college, it’s better to invest sooner than later
While the primary reason for investing is financial independence and personal retirement, the next favorite is investing for our amazing kids. Even more popular is investing for the beautiful, brilliant, and incredibly talented grandkids.
Kids aren’t able to invest directly; you have to be an adult to open an investment account. Adults investing for kids get to choose how the accounts are arranged and have three primary choices.
An account can be “earmarked” for the child with title remaining in the names of the owner. Many times, our mom and dad clients would elect this approach when they wanted to regularly invest for the kids but might also have concerns that life could get in the way of their plans. This idea is appealing when there are concerns that the years between now and college may produce other needs for the earmarked monies.
Often parents are also concerned that perhaps their child won’t need the money. They could be eligible for assistance or scholarships or possibly one day choose not to go to college. Earmarked accounts belong to the owners. As the investment grows, the returns are reported to them. Some might view this aspect of earmarked accounts as a negative. However, investments with a growth orientation tend to have small taxable dividends and more of a future, lower tax, capital gains outcome. Many view the taxation to mom and dad as a minor negative factor and a tradeoff in allowing greater control.
Many parents like knowing that they decide when, how much, and even if the kids get the money set aside in the earmarked account. This approach can be for multiple children and gives the owners all the discretion and control of the monies invested. One major advantage for owners of kids’ accounts is starting them when the kids are still very young.
The more years between starting and needing the better.
Investing is most beneficial when we have longer timeframes to soften the occasional declines that come in our markets. And rates of return in investments tend to make the job of having enough saved easier than the “safer” lower earning alternatives.
Another way to arrange a kids account is to establish a custodial account. This arrangement has one adult and one child. Deposits are gifts to the child. When the child is “of age,” 18 in California, the custodial arrangement ends. At the time of the first deposit, the adult can specify to age 21 and to age 25, if arranged with monies from a trust.
Custodial accounts report earnings in the Social Security number of the child. Kids don’t have earnings of their own, so nearly no or very little tax. Earnings on the custodial account are subject to “kiddie tax” rules. No tax on the first $1,100 of earnings; taxed at the child’s rate on the next $1,100; and over $2,200 taxed at the parent’s marginal rate. Just think about how much needs to be invested to produce the earnings for taxes to apply.
Many people, especially grandparents, like this choice because the money invested always belongs to the child. We all wonder if the kids will be making good life choices when they become “of age.” Some of us remember being somewhat impulsive ourselves at 18, 21, or 25. Still, it is great to have set aside something just for this child. Maybe they use it for college, maybe for their first car, or maybe it helps with their transition to independence or hey, perhaps the honeymoon after they fall in love.
With a custodial account, it’s up to the child to decide how to use it and once it is theirs they can even keep it and use it to build their own future financial independence or start that retirement nest egg.
Another alternative is education savings accounts available under tax code section 529. These accounts are arranged with an adult owner and a child beneficiary. Contributions can be significant, up to $15,000 per child per year and plans allow for aggregating five years of contributions or $75,000. 529 plans grow with no taxation and provide for tax free withdrawals when the beneficiary is experiencing education and related expenses to include room rents, internet fees, tuition, books, and lab fees. Nearly all education related expenses are allowed just not expenses such as dining or transportation.
529 plans allow the owner to change the beneficiary to another family member at any point. Family member is liberally defined to include all relations on the family tree including parents, grandparents, aunts, uncles, nieces, nephews, and cousins. Included are adopted family members.
If there is money withdrawn from the account without offsetting education related expenses, taxes and penalties can apply. Perhaps then someone in the family, maybe even you, needs to take a creative class.
When thinking about each person’s circumstance, the most important decision is when do we start saving for education. With costs today often exceeding $15,000 per year, the sooner started the better.
One helpful tool is a university/college cost calculator, ask your financial advisor.
Until next time, stay safe!