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Friday, February 2, 2024

5 Meaningful Ways To Invest For Your Children Long-Term

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Parenting—it’s perhaps the most rewarding and expensive thing you’ll ever do. 

Oh, and by the way, you wouldn’t happen to have over a quarter of a million dollars lying around? Why, you might ask? 

Because a recent Brookings Institution study found that in today’s dollars, a two-parent household will spend about $300,000 (or $18,000 a year) to raise one (yes, only one) child in the United States.

While baffling, that study excludes a major six-figure expense: college. 

Between raising your child, saving for college, and potentially planning to help with other significant expenses, like a wedding, down payment on a house, business venture, etc., how can you invest for your children without forgoing your own financial needs and dreams?

Let’s explore intentional ways you can start investing for your children today.

College: The “Big” One

Many parents want to support their children in their pursuit of education. But before you funnel money into an account, consider your goals:

  • Do you want to help your child pay for college?
  • How much do you hope to cover? 50%? 100%?
  • Is that for in-state tuition or a private university?
  • What extra cash flow can we redirect to help support that goal?

There are several ways to help fund your child’s college education, and we’ll break down a few. 

1. Invest for Your Children In A 529 Plan

The average student spends about $35,551 per year on college expenses, including tuition, fees, and living expenses. 529 Plans could be an excellent way to help cover those costs. 

A 529 Plan is a state-sponsored tax-advantaged vehicle to support education expenses. How does it work?

You contribute to the fund with after-tax dollars. Depending on your plan, you can invest those funds, and the gains grow tax-free. You’re able to withdraw the funds tax-free if you use them for qualified education expenses, like tuition, room and board, and other necessary supplies. You may also be able to use the funds for study abroad experiences. 

If you use the money for an unqualified purpose, like travel, insurance, cell phone plans, gym memberships, etc., you may be on the hook for a 10% penalty plus income tax on the amount you withdrew. 

There are two types of 529 plans:

  • Pre-paid tuition plans, and
  • Education savings plans

What’s A Pre-Paid Tuition Plan?

Pre-paid education plans are the least common of the two, mainly because they are so niche. 

With these plans, you can prepay tuition at a qualified public or private institution at today’s rates. The benefit is that you lock in current tuition rates and can better control how much you pay in tuition long-term. This can help manage inflation and future college costs. Not all states offer these plans.

Many plans offer flexibility to use the funds for tuition at other qualified institutions if your child decides to go somewhere else. 

However, there are some notable downsides and limitations:

  • You can only use these plans for tuition, not other expenses like room and board and technology, so you’d have to save elsewhere for those costs.
  • You can’t choose your investment options. Since it’s a predetermined contract, you don’t have a choice in how the plan invests your contributions.  
  • If your child doesn’t attend college, you may not get all your money back.

If your goal is to fund tuition only and your child knows 100% where they want to attend school, pre-paid tuition plans may be a solid option. But given their smaller scope, less control, and fewer growth opportunities, you may also want to consider an education savings plan. 

What’s An Education Savings Plan?

When you think about 529 plans, your mind likely goes to an education savings plan.

These tax-advantaged tools enable you to invest for future education costs. Even though states have their own 529 plans, you don’t have to use your state’s plan if it doesn’t suit your needs. You’re able to enroll and invest in any state’s plan, so if you live in Texas, you can use New York’s 529 plan. 

We tend to like New York and Utah’s plans as they offer low-cost index funds with a strong and consistent performance track record. 

Why would you choose to use your state’s 529 Plan?

Some states offer tax deductions (or tax credits) for residents contributing to their 529 Plans. So if you’re enrolled in an out-of-state plan, you could miss out on reducing your taxable income on your state’s return. Check out this map to evaluate the benefits of different states’ offerings. 

While there aren’t set contribution limits for 529 plans, many people aim to remain within the annual gift tax exclusion limits—$16,000 per individual, $32,000 for married couples in 2022 (these numbers jump to $17,000 and $34,000 in 2023)—so they don’t need to report the contribution as a “gift” to the IRS. 

Will 529 Plans Impact Financial Aid?

Probably. An important determinant when answering this question is the account owner. If the account is in a parent or dependent student’s name, FAFSA counts 529 Plan income as a parental asset. One strategy is to have the account in the grandparent’s name so it’s not included on the FAFSA and will not affect the child’s financial aid package. 

The good news is that the first $10,000 is usually excluded from the expected family contribution, and only a maximum of 5.64% of the total parental assets will count. 

How Much Do You Need To Save In A 529 Plan?

Now that you know what 529 plans are and how they work, how much are you supposed to save?

Let’s bring in some numbers using a college savings calculator. 

Say you have a 5-year-old and want to start planning for college costs. Your goal is to save 50% of tuition at a 4-year public, in-state college. In that case, you’d have to allocate about $300 a month to your 529 Plan to meet your target. 

Remember, the earlier you start, the more time you give the investments to compound. You can also gradually increase your contributions as your child gets older and your cash flow frees up. Try not to overfund this account to maintain more flexibility. 

2. Coverdell Savings Accounts (ESAs)

Coverdell Savings Accounts (ESAs) are more restricted than 529 plans, but they can be an effective way to save for school if you’re eligible to use them. 

ESAs are education-savings trusts/custodial accounts that offer tax-free growth and tax-free distributions for qualified education expenses, including K-12 and college costs. There are, of course, some rules to understand:

  • You can only contribute a maximum of $2,000 per beneficiary
  • If your AGI exceeds $110,000 filing single or $220,000 for married filers, you can’t contribute.
  • You may have to pay an additional 6% excise tax if you contribute for a beneficiary who is 18 or older. 
  • Once the beneficiary turns 30, they must empty the account and pay income tax if they don’t use it for qualifying purposes. 

FAFSA treats ESAs the same as 529 plans, as parental assets, which it caps at 5.64%.

But when compared to 529 Plans, ESAs have some distinct benefits. First, they tend to offer more investment options. And you aren’t limited to tax-free withdrawals for K-12 education expenses—with 529 Plans, you can only withdraw up to $10,000 annually for those types of expenses. 

So if you fall within the eligible income limits and are looking for a way to help support K-12 education costs, ESAs could be a great option.  

3. Custodial Accounts

Custodial accounts can help you invest for college and beyond. The two main types are:

  • Uniform Gift To Minors Act (UGMA)
  • Uniform Transfer to Minors Act (UTMA)

With these accounts, you open and manage them on behalf of a minor. Once they turn 18 or 21 (depending on which state they live in), they become the account owner, which opens up another can of worms. Since they own the assets, they’ll have to contend with a few elements:

  • Temptation spending. Your children don’t have to use the funds for their schooling. They could just as easily use it to finance a gap year, buy a home, or spend it in any number of ways, so you have to be okay with giving your child that trust and freedom.
  • Financial aid snafus. Custodial accounts aren’t as favorable on FAFSA. Since they are considered a student asset, they could reduce aid eligibility by 20% of the asset’s value.

One Key Benefit Is More Flexibility and Fewer Restrictions on Investments

You can fund these accounts with various assets like cash, appreciated securities, property, and more. Unlike 529 Plans, in which you are restricted to a fund menu within the plan. Keep in mind that, like 529 Plans, there are no specified annual contribution limits, though many keep within the annual gift tax parameters. 

Custodial accounts tend to be more flexible for long-term expenses as you and your child don’t have to use the funds solely for college purposes. As long as you use the money for the benefit of the minor, you’re all set. For example, if your 16-year-old gets into a car accident, you can use the funds to help cover the repairs. 

These accounts also offer unique tax benefits. While you won’t receive tax benefits for contributions, the first $1,100 in earnings is exempt from federal income tax, and the next $1,100 is taxed at the child’s tax rate, which tends to be far lower than yours as the parent. 

Custodial accounts offer diverse investment options and can be an excellent vehicle for transferring assets to a child without establishing a trust.

4. I Bonds

As you know, I bonds have been making headlines as a safe, inflation-hedging investment opportunity. But did you know you could get an extra tax benefit for using the proceeds to help fund college costs? 

Typically, when you cash out an I bond, you must report the income on your federal tax return. But if you use the money for qualifying education expenses, you may not have to pay tax!

As you might expect, you have to adhere to some specific rules to qualify:

  • The bond must be in your or your spouse’s name—not your child’s name. 
  • Your AGI has to be less than $98,000 for single filers and $124,800 if married filing jointly.
  • You must cash the bond in the same year you a) claim the exclusion and b) make a qualifying expense. 

While it may not have been your first thought, I bonds can be an efficient tool to help supplement college costs. Given their inflation protection, current high yield, safety, and potential tax benefits, it could be something to consider. 

Flexible, Ongoing Options To Invest For Your Children

Even though college is an important step for many people, there are likely other big and small milestones that, as parents, you may want to help your child pay for. It’s essential to create a deliberate strategy for these expenses as well. 

5. Open A Separate Brokerage Account Earmarked for Your Child

Brokerage accounts are flexible investment vehicles that help you save for known and unknown future expenses. As a tradeoff for no direct tax advantages, you can use your brokerage account at any time and for any reason, making them quite flexible. 

You likely have a brokerage account for yourself (or with your spouse) to cover costs like a future move, work-optional lifestyle, extended travel and time off, etc. 

You can consider opening a separate brokerage account with the intention to save for future items you’d like to support, including a sports camp, music lessons, study abroad, wedding, down payment on a house, flight to Europe, business venture, medical bills, etc. 

Creating a separate fund also helps you be more intentional about what you’re giving while also obtaining control over this account since it’s in your name and not your child’s. If you have the money and want to support your child in that way, great! But if you don’t, you can simply say no and not rummage through your retirement savings to come up with the cash. 

A “family” brokerage account is also a good opportunity to both set boundaries and offer financial support when you’re comfortable. 

A Rule Of Thumb: Don’t Spend It All In One Place

While it may be easy to place all your allotted funds for your child’s future in a 529 plan and call it a day, spreading your contributions across a few different accounts may make the most impact long-term. 

Before you decide on a number, review your goals and what you can realistically spend without jeopardizing your retirement savings and other pursuits. 

Perhaps at first, you have $200 a month. Maybe you’ll start by investing in a 529 Plan while your child is young and you have time to enjoy the tax-free growth of this account, and then decide to start a brokerage account with additional cash flow in 10 years when your child is older. As you have more income to put toward these savings avenues, we can increase and add accounts accordingly. 

While you don’t want to overcomplicate your plan, it’s also advantageous to give yourself and your child options for ongoing financial support. 

Create Teachable Opportunities

When you’re more deliberate and honest about your goals and what you hope to give, it presents a wonderful teachable moment for your children about saving, investing, goal setting, trade-offs, and more. 

Maybe you and your child will work together to determine how to make the best use of the available funds and how to make up the difference with student loans, on-campus jobs, and cost-effective college (and life) decisions. 

For example, if they have $30,000 for each year of college, they may decide to take that where it goes the farthest at a state school where they also receive a scholarship and will have to take out minimal loans. But if they decide on the pricey out-of-state or private school, that money might not go as far, and they would have to take on more debt. 

Welcome the opportunity for those conversations and questions as they can help you raise financially literate children. 

Financially preparing and investing for your children is a considerable undertaking, especially considering inflation. But try not to let the “big” numbers scare you. Instead, approach your savings journey like you’d tackle any other significant financial milestone: one (baby) step at a time.

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