It is no secret that kids can cost a pretty penny – raising a child from birth to 18 years of age can eclipse $230,000, an annual expense of nearly $13,000. Once you get past parenthood’s sticker shock, as well as the early sleepless nights, many parents (and grandparents) start thinking about preparing for future expenses.
Many investors with the benefit of hindsight understand what they missed out on by not getting started earlier, which often leads them to want to give their kids or grandkids a head start. Beyond providing for a child’s everyday expenses, this may translate into a desire to begin saving for their future and to afford them a sense of financial security. If you already know that you want to start building savings to someday support a child or grandchild in their chosen endeavors, the next question is how to go about doing it.
Before we dive into the options, you must first think through the why behind your decision. It is important to get a good handle on what you hope to accomplish with these savings, and the better you can define your goal for the funds, the easier it is to determine which type of account is the best fit. Here are a few questions to prime the pump:
What is the goal? Do you want to set aside some money so the child has a rainy-day fund when they are older? Is the idea to just get them started? Or to expand the next generations range of choices? To teach the child about money and investing? To get them engaged and interested in finance? Or just to have somewhere to deposit birthday checks from relatives? Perhaps you want to leave a legacy or something for the child to remember you by. Define your goals before you and your advisor identify the most appropriate tool to pursue them.
How would you like the money to be spent? After determining what you want the funds to accomplish, think about whether you would like the money to be used for a more specific purpose or at a particular time in the child’s life. A common example is to stipulate that the funds be used strictly for education expenses or only once the child reaches adulthood. On the flip side, you may what the child to always have access to the funds.
How much control would you like to retain? Would you like to retain control of how the funds are invested and spent from the account to ensure your wishes are carried out?
Now that you have had the opportunity to examine your deeper motivations, it’s time to decide the best type of account to accomplish your wishes. There is some flexibility here; for example, down the road you can transfer a savings account or UTMA into a 529 account or a trust. The following is a high-level overview of options that are available to parents and grandparents who want to start saving:
Bank Account or Savings/Money Market Account
This can be a great place to start accumulating dollars for your kids. The pro is that these accounts are easy to set up and are accessible. In most cases, you can simply set up an account where you bank. The downside is that interest rates are very low and you won’t be earning much on dollars saved today. Many parents will use this type of account to encourage children to learn financial discipline by matching contributions. Depending on the funds accumulated and the runway for their use, you may consider investing them for the longer term.
Custodial Brokerage Account or UTMA (Universal Transfer to Minors Act Account)
The next option is a custodial brokerage account or UTMA, which can help the money work for the kid a bit more. Like the bank or savings account, this is a great option if you’re looking for simplicity and accessibility. You set up an account in your name for the benefit of the minor child. The child will have access to the account and gain full control once they reach the age of majority, which varies by state. At that time, the beneficiary (in this case, the child) can use the funds however they would like. They could buy a car or make a down payment on a new house; there is no restriction on utilizing these funds. A drawback to this type of account is that there’s no tax benefit from saving in this way.
529 Education Savings Plan
529 plan accounts are a popular choice if your objective is to provide for the child’s education. You are limited to using this money for qualified education expenses or you pay taxes and a penalty, but a 529 plan may cover K-12 education as well as college. They usually provide a state tax deduction when you make the contribution and the earnings or growth in the account comes out tax free.
Set up a trust
The most complex and costly of these options is to set up a trust fund for your child or grandchild. Given that it at least involves working with an attorney to draft the trust document, this route isn’t as common unless you plan to gift larger amounts of money over the years or if you want to retain more control over the use of the funds. Depending on how it is written, a trust can offer you flexibility in directing how the funds are used, as well as help protect that money in the future if creditor or divorce concerns arise.
Passing down wealth to the next generation or even to your grandchildren can be a powerful expression of your values. As such, it helps to know the rules around any gift you choose to make. With the current annual gifting exclusion amount, you can give any individual up to $15,000 a year ($30,000 total as a married couple) without the need to file a gift tax return. If you’re considering a large gift, it’s a good idea to consult with your advisor or accountant.
In conjunction with, or in lieu of, financial support, reflect on what you can give the next generation in the way of knowledge. How can you pass on good financial life skills and habits? Talking about money and providing opportunities to learn can be just as important, if not more important, than the dollars you put aside over the years.