As much as parents love their children, they also know there are significant costs involved in rearing children to become productive adults. A savings program can introduce children to the world of saving and investing, pay for education, meet other large expenses or simply give a child a financially unburdened boost into adulthood.
Unfortunately, there is no one savings vehicle that meets every parent’s needs. Here are the pros and cons of some of the many options available.
One share of stock – Many parents think a great way to introduce a child to investing is to buy a share of stock in a company whose products or services the child uses (usually a retail, media or technology company). Even with online brokerage services, this can be an expensive proposition. Since minors can only own securities through a custodial or trust arrangement it becomes even more convoluted. If you choose this approach, let the child choose investments worth a certain amount and use one of the many free sites that will track a “portfolio” without having to actually own the stocks. A word of caution: be sure you’re prepared to pay up if your kid hits a home run.
Savings bonds – Savings bonds offer advantages that have made them a favorite of parents for years: security, tax deferral, small incremental purchase amounts, no holding costs, the ability to use the child’s social security number and the opportunity to avoid all taxes if the bond proceeds are used to pay for educational expenses (subject to income limits). However, beginning May 1, 2005 the old standby series EE bonds are issued with a fixed rate for 20 years rather than varying the rate every six months. In today’s low rate environment, this is a big disadvantage, and series I bonds, which are pegged to inflation, become more attractive.
Uniform Transfers to Minors Act (UTMA) – The UTMA supercedes the Uniform Gifts to Minor Act (UGMA) account in Arizona and for many years was one of the few straightforward methods to transfer assets to directly benefit a minor. The funds are irrevocably gifted to the minor and an adult custodian has the responsibility to prudently invest the assets and see that they are used for the benefit of the minor. The account is transferred to the minor at the age of majority (now 21 in Arizona) and the tax advantages can be a bit confusing. (Up to age 14, the first $800 of a child’s investment income, including capital gains, is tax-free; the next $800 is taxed at the child’s rate, and income over $1600 is taxed at the parent’s rate. At age 14 the child files his own tax return.) Since the gift is irrevocable the assets are considered the property of the child and can have an impact on college financial aid qualification. As other options with greater tax advantages and greater control on the use of the assets have become available, the UTMA has become less attractive.
529 Plans – These plans are sponsored by states to allow families to save for college expenses. They have very high contribution limits, no income limits and tax deferral. Since the beneficiary can be changed to another family member (including cousins, nieces, nephews or grandchildren) the account is not considered to be owned by the child. No taxes are due if the funds are used for qualified college expenses but this feature expires in 2011 and it is unclear whether it will be extended. If not used for college expenses, the funds can be recovered and income taxes, plus a penalty, will be levied. Investments are limited to the choices in the state-sponsored plan, specific features vary by state, and there are typically some additional administrative fees. Since Arizona does not allow a state tax deduction for 529 plan contributions, as some other states do, Arizona residents are best served by using another state’s plan that has low expenses and attractive investment choices.
Coverdell Education Savings Account – The Coverdell account, formerly known as the education IRA, offers investment flexibility, tax deferral and tax exemption if the funds are used for qualified expenses. Best of all, the funds can be used for elementary and secondary school expenses as well as college. Similar to a 529 plan, the beneficiary can be changed and therefore the account is not considered the property of the child. Unfortunately, the annual contribution limit is ridiculously low at $2,000 and there are parental income limits (adjusted gross income of $95,000 for a single parent and $190,000 for married parents).
Prepaid tuition plans – These plans were initially established by states for their public university systems, and in 2003 a group of over 200 private colleges and universities introduced their own plan. The idea is to pay a fixed amount now for a guarantee that tuition at the participating schools would be covered in the future. Tuitions have increased much faster than inflation over the past 20 years, so in return for sacrificing the flexibility of the other options, you are protected from the risk that tuition will increase faster than the portfolio value. These plans also offer features to deal with a beneficiary child that doesn’t attend college and other problems. But they are not without risk; several states have had to revamp their plans when faced with funding shortfalls.
Individualized trust – An individualized trust offers the ability to be very specific in the uses and conditions associated with the assets. Because of the additional cost, administration and complexity, such a trust is only feasible with significant assets or unique circumstances.
Zero coupon bonds – Rather than pay interest, zero coupon bonds are sold at a much lower price (known as a discount) than the face value and increase in value each year until they reach face value on the maturity date. The attraction of these bonds, especially for grandparents, is that a relatively low investment makes a specific amount of funds available at a future date. The problem is that even though “zeroes” don’t pay interest, taxes are due on the increase in value, and as described above with the UTMA, that tax burden typically falls on the parent. If the bond has to be sold before maturity, market prices can be very volatile.
Roth IRA – If your child has reportable earned income (not investment income), a Roth IRA should be considered. The Roth can be funded up to the amount of the income or $4,000, whichever is less, and the contribution does not have to be the actual money earned; a parent can make a gift of the contribution and the child can get the satisfaction of using the earned money for whatever his goal may be (a car, travel, other savings, etc.) Withdrawals can be made without penalty from a Roth to pay for educational expenses and although any gains would be taxed as income, the student’s income tax rate would be very low. (The contribution amounts can be withdrawn without tax after five years.) If the Roth is not needed for college expenses, the child will have a tremendous head start on his retirement saving and will have learned the value of long-term investing.
Segregated account – It may sound overly simplistic, but saving for a child’s benefit in a separate account in the parents’ names does have advantages. The parents retain full control, have broad investment flexibility, dictate the use of the funds, and have the funds available for other family emergencies. Of course, there are no tax benefits and the ability to use the funds for other purposes can be dangerous if the parents do not have financial discipline.
If you’re more confused than ever by these options, remember that the much more important decision is to begin saving for your child as early as possible so the power of compounding can work to ease the financial burden of your bundles of joy.