By Sue Bogoevska
Every parent and grandparent wants the best financial experience for their children and grandchildren. The hope is to pass along the wisdom of their experience, so that their offspring avoid pitfalls and benefit from better financial choices. Making good financial choices can have particularly significant benefits for children and grandchildren. In our capitalist society, dollars can open doors and provide opportunities. Saving early in the correct savings vehicles can allow you and your children (and their children!) to reap the rewards of the time value of money and compounding interest. So, the question to ask your kids is: Would you like a dollar now, or $1 million later?
Ways to Save
There are a number of savings vehicles available, and some offer significant tax benefits. 529 college plans, custodial accounts, and Coverdell Education Savings Accounts are some of the most popular options.
Gifting: Anyone can gift up to $14,000 per person per year with no gift tax. Rather than giving an outright gift, though, consider savings vehicles that offer additional benefits.
529 college plans: instead of simply providing a monetary gift, consider putting the money into a 529 college savings account. You can deposit up to five years’ worth of gifting in advance, for a total of $70,000 for 2016. 529 plans have a number of tax benefits, including:
- State specific plans, which may offer an income tax deduction or credit, in addition to a variety of investment options.
- The monies grow tax-free if they are used for college education expenses.
- Account balance may be transferred to an eligible family member without taxation.
It is important to keep in mind that a 529 account is established individually for each minor, although multiple donors can contribute to it. Additionally, having a 529 account may affect financial aid eligibility for the student.
Custodial accounts: Custodial accounts can be brokerage or bank savings accounts, and, like 529s, there can only be one minor per account. Custodial accounts are characterized by the following:
- Up to age 14, dividends and capital gains are taxed at the minor’s tax rate. Then they are taxed at the parents’ tax rate.
- The custodian controls the account for withdrawals & transactions.
- Once minor reaches age of majority (18 or 21), the account is owned by the minor.
- There are no limits on contributions.
- Investment choices are whatever is available through the firm.
Coverdell Education Savings Account: These education savings accounts can be used for elementary and secondary school, in addition to college.
- These accounts have a $2,000 annual contribution limit.
- There is an income restriction on donors to a Coverdell Education Savings Account (must be under $110k modified gross adjusted income for an individual, $220k for joint filers to be eligible)
- Contributions are only permitted until the minor turns 18.
- Monies can be withdrawn tax-free if used for qualified education expenses.
Trust account: If you’d like to put money aside to benefit multiple beneficiaries, and be able to place restrictions on the use of the monies, another option to consider is creating a trust. This requires an attorney to draft the document and customize it for your goals.
As you look at different savings options, there are a few things to keep in mind:
Are there yearly limits on contributions?
Does the income level of the donor affect eligibility?
Is the growth on the monies taxable?
When can you withdraw monies without penalty?
What can I spend the money on without penalty?
At what age does the minor have access to the monies?
Time Value of Money + Compounding
The biggest benefit of starting to save early for your children and grandchildren is that it allows you to maximize the time value of money and compounding. Here’s an example of how significant the impact can be:
For a newborn, you start an account and begin depositing $100 per month. Using a 5% annual interest rate, compounded monthly, at age 18 the balance is $34,920. That could definitely help with college education costs.
Kids can also start saving for retirement early to take advantage of tax benefits (it’s never too early!). Or family members can reward the industrious child by matching their income. For kids that are working and have earned income, Roth IRAs are an additional savings vehicle that’s geared for retirement:
- The current contribution limit is $5,500 per year, for 2016.
- Monies grow tax-free, and are available without penalty at age 59½ if they have been in the account for at least five years.
- There are no required minimum distributions as compared to other retirement accounts.
It’s important to remember that the minor must have earned income in order to be eligible for a Roth IRA.
Here’s an example using a Roth IRA:
At age 16, you deposit $5,500 for year one, assuming earned income of at least that amount. You make monthly contributions of $458.33 earning 6% annually, compounded monthly. Do this for 44 years and at age 60, your grandchild now has an account valued at $1,261,013.57. The best part of a Roth IRA is those monies are now available tax-free.
For the next birthday or holiday, as you’re debating buying the latest video game or must-have shoes for your adorable child or grandchild, consider investing those dollars for their benefit instead and watching that gift multiply over time. You may not be able to buy love, but the recipients of your generosity will most certainly remember you every time they see their statement balance.
What a wonderful gift that leaves a lasting impact and significant financial legacy.
As always, seek advice from your tax advisor to ensure you understand implications of your choice and personal situation.
At Portfolio Solutions®, we design, implement, and maintain dedicated portfolios using low-cost, passive investing strategies so our clients keep more of what the global markets offer. We would rather see investors earn more by controlling their investment costs than by taking unneeded, additional risk in their portfolios.
