Saving Money For Kids – A Primer On Kids Accounts

Good morning all! Over the weekend I was talking on Twitter with my friends Penny from She Picks Up Pennies (pssst….did you miss her breadwinning mom interview here?) and ZJ Thorne about all the different kinds of accounts you can use to save money for kids. They both had a lot of questions – likely more than can be answered in 140 characters – although I did try! From doing my own research on saving money for kids, I know for a fact that it’s really hard to find good information on this subject that’s both consolidated and explained in a simple, straightforward way. Enter Chief Mom Officer.

As the mother of three kids ages 13, 9, and 2, saving money for kids is a subject I’ve researched a lot over the years. There are so many different options for kids accounts, and they all have different pros/cons, that it can become overwhelming and you might not know where to start. So I’ve decided to start a new series on kids and money to help all my readers with all their kid & money questions. And there’s no better way to kick it off than by running down all the most common types of accounts.

Have a question for me to add to my list? Drop me a note a liz@chiefmomofficer.org or leave me a comment – I just might feature it on the site!

So good news, fellow overwhelmed parents – I’m going to clear away the confusion and give you a quick run-down of the different options you have for accounts for saving money for your kids, the pros/cons of each, and some links to go learn more details if you’re looking to do more in-depth research.

The First Question You Need To Ask – And Where I Have My Kids Money

The first thing you want to ask yourself when deciding what kind of account you’ll need is “what kind of goal is this money for?” Just like with an account for yourself, you can’t pick the right account for your kid until you know what goal you’re aiming for. In my primer on kids accounts below, I’ve given you some information on what you might use each type of account for.

For instance, take my three kids. They all have multiple kinds of accounts, but that’s because they serve different purposes and they’re for slightly different goals. I also have different accounts simply because I don’t want too much locked up in a college-only account. Let’s look at the breakdown of where my oldest sons money is held for a real-life example:

• 61.5% in two different 529‘s
• 25.7% in I Bonds
• 11.6% in mutual funds held in an UTMA/UGMA
• Remainder is in a single stock (Nintendo) that I use to teach him about the stock market, and a passbook savings account

Not sure what these are? Stay tuned and I’ll explain.

As he approaches college, I’m going to also have an after-tax savings account in my name specifically set aside to capture the American Opportunity Tax Credit (AOTC) and the Lifetime Learning Credit (LLC), or whatever equivalent credits exist when they go off to college. I can’t take the credit by paying for college from funds that are in their name, or from funds in 529’s. Of course tax law may (will) change in the next 4-16 years, so as I mentioned in my popular College Compact article, I’ll be reviewing law changes and adjusting my compact annually.

In addition, once he has earned income I’ll open a ROTH with him and offer 100% match from “The Bank Of CMO”. This is something my father did for me when I was 16 and got my first job, and I still have that account today. I learned a lot about investing and retirement savings, and it enforced the importance of starting early. So I want to pass on this tradition to my boys.

Saving Money In Kids Names – A Quick Primer

As promised, here’s a quick run-down of the different kinds of accounts you can consider for your kids, the pros and cons of each, and the tax consequences. A disclaimer – since this is a quick run down, I can’t get into all the details of each one, and I’m not a CPA. So if you have detailed tax questions you should consult a real professional-I’m just a hobbyist.

Savings Accounts for Kids

What is it? An after-tax account in your kids name, with you as the custodian. This account pays interest and is completely safe (backed by the full faith and credit of the US government). You can have a savings account online or with your local bank (passbook savings)

Good for: depositing birthday and Christmas money, as well as allowances.

Pros

• Easy for kids to see and understand
• Can use this to teach everyday saving
• Demonstrates how interest is applied
• No limit to contributions except the gift tax limits ($14k per year per giver)
• Safe – pretty much no risk that account will go down

Cons

• Interest is fully taxable (but at the kids rate-subject to “kiddie tax”)
• You make hardly any interest at today’s rates-losing money after inflation
• Child has full access to account after age 18 (Corvette/Mercedes, here they come!)

Custodial Accounts – Mutual Funds, Stocks, and Bonds  (UTMA/UGMA) For Kids

What Is It? The same kinds of mutual funds, stocks, bonds, ETF’s, etc. that you can open yourself-but held in your kids name. You can pretty much open an account anywhere – Vanguard, Fidelity, Schwab, or even some of the robo-advisors offer custodial accounts.

Good for: Longer-term goals for kids that you want to be in their name but not only used for college. For example, sometimes parents are worried about using 529’s because of the lock-in to college, or sometimes parents want to have an account for things like weddings/home down payments/starting businesses. Also great to use to teach kids about stocks, bonds, or mutual funds.

Pros

• Easy to open
• Potential to make a lot more money than a savings account
• No limit to contributions except the gift tax limits ($14k per year per giver)

Cons

• Dividends/capital gains are fully taxable  (but at the kids rate-subject to “kiddie tax”)
• Risk of losing money, just like if you bought your own mutual funds/stocks/etc.
• Can be difficult for younger kids to understand how these accounts work
• Child has full access to account after age 18 (Party on mom and dad!!!)

529’s for Kids – College Savings

What Is It:  The king of college savings, this is an account intended to be used specifically for college, you can get tax-free growth for qualified education expenses. Offered in almost every state, you need to see whether you get a tax deduction and how it works to decide where to invest. Check out Mama Fish Save’s awesome article on the topic for more. If you’re interested in gifting a 529 to someone else, I wrote a detailed post on the topic last Christmas.

Good For: Only college and associated expenses.

Pros

• Easy to open
• Growth is tax-deferred, and tax free when used for college
• Account belongs to the parent, not the kid-so they can’t take off and buy a Mercedes with the money at 18
• If one child doesn’t go to college, you can use the money for another child (or yourself)
• Contributions are limited only by gift tax limits-currently 14k per year, or you can superfund up to five years contributions – (check out this article from Bayalis Is The Answer for more)

Cons

• If you use the money for something besides college, you’ll not only pay taxes but also a penalty (on the earnings only)
• Investment options can be limited, or even poor, depending on your state
• State usually limits how much you can deduct of your contributions in a year
• There is an account size limit, but it’s very high (a few hundred thousand)
• Taxes are at the parent’s rate if you incur them

IBonds/EE Bonds – Savings Bonds For Kids

What Is It? Savings bonds are intended to provide interest, and are really a loan to the government. They are considered safe since they are backed by the full faith and credit of the US Government. I-Bonds are indexed to inflation, and EE Bonds double after a guaranteed period of time. You can get savings bonds in your child’s name, usually through Treasury Direct nowadays. They used to sell paper bonds at the bank, but now you can only get them by using your tax refund.

Good For: College and non-college goals. Best if you have a few years to go, but not a very long time where stocks/bonds would likely beat I Bond/EE Bond rates.

Pros

• Can be tax free if used for college – pay close attention to how you structure the ownership of the bond if you want to do this. The child can’t be the owner or co-owner, just the beneficiary.
  Can grow tax deferred if you decide you don’t want to pay taxes every year
• I Bonds will keep up with inflation, and EE bonds and guaranteed to double. So for an extremely safe investment the interest rate is very good (I have some at 4%!)

Cons

• These belong to the child at age 18 if they’re the owner or co-owner (partaaaay)
• You’ll need to pay taxes on the earnings at your ordinary income tax rate, if you don’t use it for college
• Treasury Direct is a pain to use and arguably doesn’t provide as much protection as the paper bonds did

Coverdell Educational Savings Account (ESA) for Kids

What Is It? An account that’s similar to a 529 in some ways, this account can be used for any education expenses-not just college. This makes it a good choice for those attending private school. Not every investment company offers these, so you’ll need to ask. For example, Fidelity and Vanguard don’t offer them. You can get one through TD Ameritrade though.

Good For: Private school in K-12 (including religious school) and college.

Pros

• Tax free withdrawals if used for education expenses
• Account belongs to the parents, not the child (no party, sorry Junior)

Cons

• Contribution limits are very low ($2k per year per beneficiary)
• Contributions aren’t deductible and you have to pay taxes at withdrawal if not used for education
• Income limits are low, especially since this account would probably be used by someone sending their kids to private school

ROTH IRA for Kids (More Likely Teens)

What Is It? This is an account that you fund with after-tax money, that will grow tax-defered and can be withdrawn tax-free for retirement. Tons of options – you can pretty much open this account wherever you want. Vanguard and Fidelity would be my top picks

Good For: teaching kids about retirement savings and delayed gratification during their first job.

Pros

• Account is extremely flexible-contributions can be withdrawn anytime  with no tax consequences
• Child could use the account without penalty for non-retirement expenses like college or buying a home

Cons

• Account belongs to the child at age 18, so they can choose to cash it out
• Penalty applies if not used for retirement or one of the IRS exceptions
• Child has to have earned income, and you can only contribute a maximum of what they earn
• Limited to $5,500 per year

Traditional IRA For Kids (More Likely Teens)

What Is It?  This is an account that you fund with after-tax money, that will grow tax-deferred and can be withdrawn (but taxed) for retirement. Tons of options – you can pretty much open this account wherever you want. Vanguard and Fidelity would be my top picks

Good For: teaching kids about retirement savings and delayed gratification during their first job.

Pros

• Child could use the account without penalty for non-retirement expenses like college or buying a home
• Great way to teach kids about retirement savings at a young age

Cons

• Account belongs to the child at age 18, so they can choose to cash it out
• Penalty applies if not used for retirement or one of the IRS exceptions
• Need to pay taxes on withdrawals – and if you’re investing for a teen, their tax rate is only going up.
• Child has to have earned income, and you can only contribute a maximum of what they earn
• Limited to $5,500 per year

Of course, I haven’t addressed every last type of account. I haven’t touched trusts (living revocable or otherwise), real estate (really complicated), or business ownership for kids. But I’m hoping this list can be a quick go-to on the different types of accounts and what you might use them for. Know someone who just had kids and might want to learn about money, but hasn’t had the time to do the research themselves? Send this article along to them.

If you want me to cover a certain type of account in more detail, have a question, or want to discuss your specific situation – leave me a comment (or drop me an e-mail at  liz@chiefmomofficer.org if you want to take in private). I always love talking money with my online friends!

Learn More:

• Savings Accounts, including  what is a passbook savings
• Custodial accounts for kids – 5 things to know
• I Bonds and EE Bonds through Treasury Direct
• 529’s- What is a 529 plan?,  Morningstar 2016 college fund ratings, An overview of different options for saving for college, Detailed information on tax deductions
• All about ROTH IRA’s, and Traditional IRA’s including what qualifies as income for kids

Want to learn more about teaching kids about money? Check out this great page with my top articles and resources I’ve found from around the web.

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