Recently, longtime clients of mine had a baby, and called me to set up an investment account for her. No, this was not an ‘oopsy’ baby! The couple are in their early 30’s. But mom’s parents are clients, and they started an account for HER with me, and now she and her husband are doing the same for their first child. The question was, what type of account should we set up? If you have listened to my podcasts, or heard me on ConnectFM 107.9 over the past ten years (Tuesday mornings at 8:35 ☺), you won’t be surprised to hear that I have a different spin on saving for your kids or grandkids. Below I will share some of the most common account types, and the traditional take on pro’s and con’s.
The first thought is that you want to save for a college education, and there are a couple of options for that. There’s the Education Savings Account (ESA or Coverdell Savings Account). The upside to the ESA is flexibility. You are not locked in to any college, or state. As long as the funds are used for qualifying educational expenses they grow tax free, and are not taxed upon withdrawal. The cons are that you are limited to $2,000 per child per year, and the child must use the funds by age 30.
The other big option is the 529 Plan. This one doesn’t have the restrictions of the ESA, but you need to be careful with how they allow you to invest your funds. Some are more restrictive than others.
If you just want to give money but don’t want the funds restricted to educational purposes, can set up a UTMA, OR Uniform Transfer to Minors Act account. The main idea here is that any taxable income is transferred to the minor who would presumably be in a lower tax bracket. Do you see the connection here? Most all of these gifting programs have a tax savings hook. But that benefit comes at a huge cost, in my opinion.
Early on in my 30 plus years of practice, I would have parents come to me who had previously set up accounts like those above and say, ‘My kid doesn’t want to go to college. Now what?’ In many cases then, when the money is withdrawn there are not only taxes to pay, but penalties as well! That tax savings strategy suddenly became very expensive.
UTMAs were very popular in the 90’s, but not so much in the early 2000’s when I would get calls like this: ‘Chuck, Junior just turned 18, and found out we have this account for him. He wants the money to buy a Monster Truck – what can we do?!?!’ Well, at the age of majority, the money is Juniors…. Help him pick out a nice one…..
As I saw more and more of these situations arise, I began using a different approach when a client wants to invest for their kids – a Transfer on Death account, or TOD.
With a TOD, the money stays in your name. The child is listed as a beneficiary if something happens to you. It is also a way to keep accounts separate, so that everyone knows that this money belongs to Junior. Except that in lieu of saving a pittance in taxes (unless you are talking serious six figure gifting, the tax savings usually don’t amount to much), you maintain FULL CONTROL over the funds until you think Junior is ready for them. Monster truck? Not gonna happen. There will be money for college if he or she decides to go. If not, how about using it to help with that first house, or start a business, or….. whatever YOU think is best.
Be careful before you decide to lock money up for a specific goal that is so far down the road. Life is full of surprises, and that small tax savings could come at a huge cost.
If you have any questions you’d like me to address, email me at CJohnson@GuardianPlanners.com.
Chuck Johnson and his wife Beth have lived in the DuBois area most of their lives and have lived at Treasure Lake since 2009. Chuck holds the ChFC and CASL designations from the American College and is the owner and principle advisor of Guardian Planners, working in the financial services industry since 1988.