How Best to Save & Invest for Kids

Albert Einstein believed compound interest was the eighth wonder of the world. He said, “He who understands it, earns it; he who doesn’t, pays it.” The simple way money grows is over time so it makes sense to start investing early for kids when they are young. The greatest asset they have is time.

Whether you are a savvy parent, grandparent or other family member, you might have wondered what you can do financially to help pave the way for the young humans in your life.

Savings can be education focused or not, and often tax-advantaged. Since the average cost of going to a public 4-year university has crept up to over $25,000/year, let’s first explore how to save for college.

Education-Focused Saving/Investing

There are two types of education savings accounts.

Coverdell – also known as an Education Savings Account (ESA)
529 Savings Plan – in Oregon it is commonly known as the Oregon College Savings Plan

The profits earned in both types of accounts grow tax-deferred. Distributions are tax-free, as long as they are used for qualified expenses (tuition, fees, books, supplies, equipment and most room and board charges). Money that is not used for qualifying college expenses is subject to income taxes plus 10% penalty. Contributions can be made until the due date of the contributor’s return or April 15.

Coverdell

Contributions are not deductible.
The funds can be applied to elementary and secondary private school as well as college.
You can only contribute a maximum of $2,000 per year per beneficiary regardless of number of accounts so it doesn’t work as well as the 529 plan for allowing, say, grandparents or other relatives to contribute.
There are contribution limits for taxpayers – under $110k/yr for single and $220k/yr for joint filers. This is based on the Modified Adjusted Gross Income (MAGI).
Contributions can’t be made past age 18.
A Coverdell ESA must be used by age 29.5.
Even though the ESAs have been somewhat overshadowed by the 529s, they still offer the most investment flexibility.

529 Plan

A 529 plan is state-sponsored.
Any resident of any state can invest in any state’s 529 plan.
There can be tax advantages for state residents.
In Oregon, there use to be a set maximum tax deduction, but that changed in 2019 to a tax credit up to $150 for single filers/$300 for joint filers based on your income and contribution.
It can be used for elementary or secondary schooling now, but keep in mind that these types of tax-free withdrawals are limited to $10,000 per year for tuition costs.
There is no income limit for contributors.
If the child does not need or use all of the money in the account, it can be transferred to another sibling, relative or even non-relative.
Different than an ESA, a 529 plan has a lifetime maximum account balance of $400,000 in Oregon. This varies by state based on the qualified higher education expenses in that state.
The account is only eligible to be invested in the limited funds designated by the state.
There is a 529 Prepaid Plan for locking in tuition costs early, but we do not recommend these.

Due to recent tax law changes in the past couple of years, there are fewer differences between the ESA and 529 accounts. In 2017, the 529 expanded to cover K-12 education as mentioned earlier, and in 2019, apprenticeship programs were also added to the 529. The SECURE Act also opened up the possibility of using 529 funds for repayments on any qualified education loan up to $10,000 for the beneficiary or a sibling of the beneficiary – up to a $10,000 lifetime maximum, per person.

It’s important to be aware that both the ESA and 529 can negatively affect financial aid eligibility. These accounts are considered assets and will reduce need-based aid by a maximum of 5.64% of the asset’s value.

Non-Education Focused Saving/Investing

Now let’s look at the other savings options for minors which can be used for other important expenses. By law, these types of accounts require a custodian or guardian to control the assets and make all the investment decisions until the age of majority at which point the account is turned over to the child. This age is different in each state. In Oregon, the age of majority is age 18, but next door in Washington, it is age 21.

Minor Roth IRA

If a kid of any age has a part-time job with earned income during the year, an investment option with tax advantages is a Minor Roth IRA. Contributions are not tax-deductible, but they grow tax-free. You can contribute the total of the child’s gross wages, up to a maximum of $6,000 in 2021. If the child makes under $600, you don’t have to worry about filing a tax return. Potentially they can still earn up to $12,000 without owing federal taxes. The other benefit is that contributions (not earnings) to a Roth can be withdrawn penalty- and tax-free at any time for any reason.

One big benefit is that the FAFSA (financial aid for college) does not ask about the value of Roth IRAs since they are usually designated for retirement.

UGMA/UTMA Account

The last option with no tax advantages (after the first $1,000 earned) is to save inside a UGMA/UTMA account (Uniform Gifts to Minors Act/Uniform Transfers to Minors Act). These accounts can be invested in a variety of investment choices, but realized earnings along the way are considered taxable to the account owner. Contribution and earnings can be used for any reason at any time.

If you think your child may apply for financial aid for school, UGMA/UTMA accounts may not be your best option since they are weighted 20% in FAFSA calculations.

We encourage clients to seek our advice when considering all your choices for saving and investing. Also, be sure to check with your tax preparer for any unknown negative consequences that your decision may have on your tax return. More information on the Oregon 529 account can be found at oregoncollegesavings.com, including the option to open an account with as little as $25.