Dear Carrie: I would like to open a savings account or a Roth IRA for my 6-year-old son. What do you think? — A Reader
Dear Reader: Saving on behalf of your son is, of course, a great idea — and the earlier you start, the better for him. But deciding to save for a child’s future is the easy part. The harder part is deciding the best way to do it. And that depends on your purpose for saving. So before you choose an account, you need to think about your ultimate goal.
If it’s as simple as teaching your son how to save, an old-fashioned savings account is a good place to start. In just a few years that goal could be to have him learn a bit about compound interest and experience the satisfaction of watching his balance grow.
But I suspect you’re thinking bigger — that you want to give him a financial head start. That usually means four possibilities: saving for extras while he’s still living at home, saving for college, saving for adulthood or even giving your child a head start on saving for retirement. Of course, these aren’t mutually exclusive, but there are different types of investing accounts for each. Here are some of the primary choices:
Building a Nest Egg for Your Child’s Future? Open a Custodial Brokerage Account
If you want to start saving money for your son in a more general way, for instance for summer camp, lessons, a school trip or even a nest egg for when he leaves college, you could open a custodial brokerage account in your son’s name.
Each parent can give a child up to $14,000 a year without having to file a gift tax return. As long as your son is a minor, you would control the account and manage and invest it appropriately. At 18 (or 21 or 25, depending on your state’s laws), the money would be his.
A custodial account can be a good way to save, but there are a few issues to be aware of:
–The “kiddie tax.” A custodial brokerage account for your son is taxable but because he’s a minor, the so-called “kiddie tax” rules apply. Under these rules, in 2015 the first $1,050 in investment income is tax-free; the second $1,050 is taxed at his rate (presumably lower than yours). After that, the income is taxed at your rate.
–The impact on financial aid. When determining aid eligibility, 20 percent of a child’s assets are assumed available for college (assets in a custodial account belong to the child). In contrast, only 5.64 percent of a parent’s assets are considered “up for grabs” in determining aid packages.
–You ultimately lose control of the account. When your son takes ownership of the money once he’s no longer a minor, he can do whatever he wants with it. If you want more control for a longer period of time, consider a trust account.
Saving for College? Consider a 529 Plan
If saving for college is a top priority, 529 plans offer two very powerful incentives. First, money invested in a 529 grows tax-deferred and withdrawals, including investment gains and income, are tax-free when used for “qualified” expenses for college (tuition, room and board, books, computers, etc.). Second, a 529 plan is considered a parent’s asset, so there’s less impact on financial aid.
You can invest quite a lot in a 529. Lifetime contribution limits are upwards of $200,000 — and even other family members and friends can contribute. But it pays to shop around. Some states offer 529 plans with additional tax incentives; some plans have better investment choices and/or lower expenses.
Giving Your Child a Jump on Retirement? Choose a Roth IRA
It’s a wonderful thought to want to help your kids plan for their eventual retirement, but any kind of IRA can only be funded with earned income from the account holder. So your son won’t be eligible until he has a job, ideally with a 1099 or W-2 form.
When he does have earned income, however, a Roth is the way to go. Unless he makes a lot of money at a very young age, he’ll likely benefit more from the future tax-free withdrawals of a Roth IRA as compared to the initial deductibility of a traditional IRA. While your son is still a minor, you can open a custodial Roth IRA on his behalf and deposit as much as he earns up to an annual limit (currently $5,500 but this will likely increase in the coming years). This is a great way to jump-start his retirement savings.
When I was a kid, saving typically meant either a piggy bank or a passbook savings account. (I had both.) But for today’s kids, saving can also mean investing, and you have a wide range of choices. The right choice will depend on what you’re saving for. Your son is lucky you’re thinking ahead and planning financially for him.
Carrie Schwab-Pomerantz, CERTIFIED FINANCIAL PLANNER ™ is president
of the Charles Schwab Foundation and author of “It Pays to Talk.” You can e-mail Carrie at firstname.lastname@example.org.