How to Invest for Your Child's Future

It seems to be baby season. We’ve already had a FinGym baby this year and there is another on the way!

We often get questions from new or soon-to-be parents who want to know the best way to save for their children’s futures, so we wanted to break down a couple of the most common ways to save for college or other needs.

The two most common ways to save for a child’s future is to use a 529 or an UTMA/UGMA.

529s are the most common way we see people invest for their child’s future. Depending on the state you live in, they can give you a tax advantage in that they are deductible from state taxes, the money grows tax free, and you are not taxed on gains when you withdraw the money for education. Due to changes implemented in the Tax Cuts and Jobs Act, you can also use them for private education before college. 

529s do not have a profound impact on the FAFSA that your child may fill out when they attend college if they may be eligible for need-based aid. In addition, grandparents and others can contribute to them, as long as you don't go over the yearly limit of 10k in contributions (for couples married Filing Jointly) between all contributing parties. 

The disadvantage of a 529 is that people worry that their child may not want to go to college, in which case when the money is withdrawn you'll have to pay income tax and a 10% penalty on earnings. (It's important to note that you will not pay a penalty on the contributions). Many do not see this as a huge deterrent for a number of reasons. One is that even in the event a child does not go to college, it can also be used for other types of educational programs, like trade or vocational programs. Another is that the funds can be transferred to another child if they are not used for educational purposes for the child they were originally intended for.

You can choose your investments, but you'll choose a portfolio rather than individual funds or stocks. As is the case with most investing, how aggressively you invest the money is a function of how long it will be before you need to access it. When your child is very young, you will want the money to be invested more aggressively than if they are rapidly approaching the age of 18.

Another option for investing for children is to use an UTMA or UGMA. UTMA stands for Uniform Transfer to Minors Act and UGMA stands for Uniform Gifts to Minors Act. These are basically just custodial investment accounts in a child's name, and they can be used for anything, not just for education. It is important to remember that these are irrevocable gifts, and therefore cannot be taken away from the child. These accounts are also not transferable to other children.

UTMAs and UGMAs have a couple of advantages. One is that these investment accounts do get a child's tax rate, so they are tax advantaged (although you should speak to a tax professional to fully understand some of the distinctions applicable to a child’s unearned income). In addition, they cannot be touched by creditors or other family members in the event of a parent or guardian’s death. 

However, they do come with 2 disadvantages. One is that they will impact a child's FAFSA more since they count towards a child’s total assets. That means that if they are otherwise, based on income, eligible for need based aid, these assets would count against that. The other disadvantage is that they become accessible to the child at the age of 18 or 21, depending on the state you live in, and a lot of people don't really think that 18 year olds are ready for managing a large amount of cash on their own. (And once a child reaches the “age of majority” in your state, it will become a regular taxable brokerage account and be subject to the same regular rate of taxation).

The primary differences between an UTMA and an UGMA are that UGMAs are available in all 50 states, while UTMAs are available in 48 states, with the exception of Vermont and South Carolina. UTMAs also allow for real assets, like a property or a car, while UGMAs do not. For this reason, some people use UTMAs instead of dealing with the hassle of formally creating a trust. It can also be advantageous for children who will not need help funding their college education.

So there we have it. Two of the most popular ways to save for a child’s future, albeit with very different rules.