The 3 Best Ways to Save for Your Child's Future
by Mauri Elbel
When our first son was born we wanted to set up a savings plan that would grow with him over the years. I mistakenly thought this would be an easy decision and casually strolled into our bank with a check an d babbling baby in arms.
But it wasn't as simple as I had envisioned. I was blindsided by myriad savings tools available, each containing various risks and benefits.
My financial inexperience coupled with an impatient infant made the process daunting. I cowered in the face of indecision, opting instead for a regular savings account even though higher-earning plans were out there.
Three years later and none the wiser, I re-entered the same building and scenario, this time with two children in tow. After our second son arrived, I naively thought I'd be able to make a better choice. I wanted to pick a more sensible plan for him and transfer the funds we had been saving for our oldest son into the same type of account. But once again, I was intimidated by the countless options and feared the unknowns.
Fortunately for our family, time is on our side -- and lucky for you, some of the groundwork has been done. A few savvy financial experts who provide advice to hundreds of families each year have weighed in on this subject to come up with three of the best savings options for parents ready to invest for their child's future.
1. 529 College Savings Plans
In a nutshell, 529 plans -- so named because they are authorized by Section 529 of the Internal Revenue Code -- were created as a simple, tax-advantaged way to help families meet future college costs. And if college savings is the goal, 529 plans make sense because of their tax advantages, flexibility and the fact that you retain control of the assets.
"If you have a pretty good idea that at least one of your children is going to college, then the 529 is the way to go," said Gil Armour, a certified financial planner for the past two decades who works at SagePoint Financial Inc. in San Diego.
A 529 savings plan is typically based on the performance of mutual funds and has no guarantee on returns. In other words, it's subject to market risk. Another option many states offer is the 529 prepaid plan, which allows you to lock in the current college tuition rate and start paying for it well in advance of a child's enrollment in college.
While this might be a good option for higher-income families and a great way to hedge against future inflation, the founder of 1650 Wealth Management in Florida, financial planner Thomas Balcom, warned that it's not cheap. Pre-paid tuition plan removes market risk because you are buying tuition as opposed to investing in securities that you will later sell to pay for tuition.
Pros: The 529 savings plan is a great long-term option and it's a solid way to invest small amounts of money for college while participating in market gains. While plans vary from state to state, a 529 makes sense for some families because of its tax advantages -- including tax-deferred growth, tax-free withdrawals, gift tax incentives and state tax deductions for some state plans -- and its flexibility, which includes higher contributions, a range of investment options and almost no restrictions on where your child goes to college or which state 529 plan you choose.
Additionally, you can tailor this plan to your goals, scaling back on aggressive investments as high school graduation approaches.
"It might be more heavily invested in stock when your child is 5 years old, but gradually over time, it becomes more conservative, which means lower risk," said Mary Voll Miller, a certified financial planner for Per Stirling Capital Management LLC in Austin and mother of two teenagers nearing college.
And if you choose a good plan with a solid track record, you don't have to constantly monitor it.
"You have a glide path," she said. Another silver lining: if the child opts out of college, you can change the beneficiary of your 529 account to another family member.
Cons: If you don't know that at least one of your children is going to pursue higher education, a 529 isn't your best bet.
And with the potential for higher returns also comes the possibility that your savings investment could decrease in value. Think back to students entering college in 2009 after the stock market crashed in 2008, Miller warned. If students' 529 plans were invested aggressively, some went down in value by as much as 30%.
Tax benefits also come with a few strings attached as to how the funds can be used -- they must be used for purposes deemed as qualified education expenses. Otherwise, "the growth of the principal if withdrawn for non-qualified expenses is subject to income tax plus a 10% penalty," Miller said.
2. UTMA or UGMA Savings Account
These are great custodial accounts that work for children too young to manage an account themselves.
You can open a Uniform Transfer to Minors Account (UTMA) or a Uniform Gift to Minors Account (UGMA) at your local bank or credit union. While the earning potential isn't as high as other options, this is an ideal choice for shorter-term goals or risk-averse people.
"If somebody can't sleep at night because a value of a savings vehicle goes down, this option would be just fine," Miller said. "But it's important to be aware that inflation is ever-present and that over time if there is no growth, your purchasing power would go down."
Pros: It's easy and safe. You can keep adding to it over the years.
Cons: You won't earn much when interest rates are low, and the child legally gets all the money when they reach the age of majority -- 18 or 21, depending on state laws -- without any stipulations that it must be used for college costs, which could be a problem if he or she is financially irresponsible.
"This is an irrevocable gift to the child," Miller said. "An alternative would be to open a regular savings account in your name and earmark it for the child so if you ever needed that money back, it would be accessible."
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3. Custodial Brokerage Account
For broader savings purposes that don't necessarily include college, financial planners give a thumbs up to custodial brokerage accounts.
"Withdrawals can be used for any purpose on behalf of the child, and there are minor tax advantages regarding treatment of the earnings," Armour said.
For those who don't consider themselves particularly financially savvy, Miller said opening a custodial brokerage account at a discount brokerage is "very, very easy to do" and recommends seeking out the amazing array of beginning investor information provided by large mutual fund companies such as Vanguard or T. Rowe Price.
Pros: If you want your money to be as flexible as possible, Armour said custodial accounts are your best bet. They are inexpensive, easy to set up and provide a solid way to set aside money for any purpose for your child.
Unlike 529 plans, which are tracked by a parent's Social Security number, custodial accounts are filed under the child's Social Security number. That means any taxable consequences are set at a lower child's rate rather than the parents' rate up to a certain dollar amount; these numbers can change year to year. These funds can be used for anything on behalf of the child -- whether it's a car or summer camp -- which is one of its biggest advantages over a 529.
Cons: A drawback of custodial brokerage accounts is that you are subjecting your savings to the risk of loss when you buy securities, Miller said. Custodial accounts are gifts to the child, and the funds become theirs at the age of majority, which could become problematic if the spending goals of the parent and child differ.
What's the Right Savings Plan for Your Child?
If college is on the horizon for at least one of your children, a 529 plan is the best vehicle by far because of its tax-free withdrawal features and relatively high contribution limits. For broader uses that span past higher education, custodial brokerage accounts get the nod.
For our family, opening a 529 plan was the clear choice because we know saving for their educational future is our goal. But every family must choose an option based on their goals and financial situation. However, one investing principle is universal no matter which plan you choose: The earlier you are able to start saving for your child's future, the better.