Financial planning for clients who have amassed wealth often includes addressing their desire to make a financial impact on their minor children’s or grandchildren’s futures. Three of the most popular and appropriate ways to invest for minors are 529 education plans, Uniform Transfer to Minors Act or Uniform Gift to Minors Act accounts, and custodial Roth IRAs. Each has its pros and cons.
529 Plans: The usual use of a 529 plan is to pay for qualified education expenses during college years. Additionally, up to $10,000 per year of 529 funds can also be used for private elementary and high school tuition.
1) The gains grow tax deferred and are tax free if used for qualified education expenses, including undergraduate, graduate, and doctoral studies, as well as, as mentioned, private elementary and high school tuition.
2) Many states offer asset protection from creditors to 529 plan owners.
3) Assets may be excluded from the owner’s estate for federal estate tax purposes up to certain limits.
4) Some states exclude the assets for purposes of calculating state inheritance tax.
5) Depending on your state of residence you could receive a tax deduction on your plan contributions.
6) A significant percentage of the account is usually excluded for calculating educational financial aid.
7) You remain the owner of the account even when the beneficiary reaches the age of majority.
8) There is flexibility in changing the beneficiary:
- If one child doesn’t use all or any of the dollars you can change the beneficiary to another qualifying family member, including one who is not an immediate family member.
- There is no limitation on time to use the funds, so you can change the beneficiary to grandchildren who are yet to be born. Keep in mind, if the beneficiary is more than two generations younger than the plan owner, the account may face generation-skipping taxes.
1) If the funds are not used for qualified education expenses the tax benefit is lost and ordinary income taxes are owed on the gains along with an additional 10 percent penalty. (Note: You would not owe taxes or penalties on your contributions)
2) There is a risk of overfunding the account especially if your child receives a scholarship, attends a military school, or does not go to college. The 10 percent penalty would be waived on distributions up to the amount of the scholarship or tuition for the military school, but ordinary income taxes would be owed on that amount if they are considered gains.
Uniform Transfer to Minors Act (UTMA) or Uniform Gift to Minors Act (UGMA) accounts: Transfers or gifts can be made to one of these custodial accounts for minors. There are no maximum limits for contributions, but donors to the accounts should be aware of IRS annual gift exclusion or lifetime exclusion limits.
The general differences between UTMA and UGMA:
- UTMA generally allows for more maturity time before the beneficiary takes ownership, depending on state rules.
- Only basic assets can be deposited in a UGMA account, whereas UTMAs allow for donations of a broader range of assets.
- UGMA is generally used for support purposes, while UTMAs can be used for more than support.
1) The assets can be distributed at any time for the child’s benefit and are not limited to specific expenses such as education.
2) Earnings are generally taxed at the child’s tax rate, which is typically lower than the parent’s. However, a certain amount of earnings is subject to the parent’s tax rate, currently anything more than $2,100; the designated amount increases with inflation.
3) The assets can remain invested for future use, such as a car, house, or wedding, or as retirement savings for the child or grandchild.
1) A tax return may need to be filed for the child depending on the amount of income and realized gains.
2) The assets would be in the child’s control once they reach the age of majority, depending on state rules. The age of majority generally ranges from 18 to 21 with a handful of states allowing for an extension to 25. Some parents and grandparents consider this a drawback to the plans, as they aren’t sure whether the child receiving these gifts will be financially responsible at majority age.
3) UTMA/UGMA transfers will be included in the donor’s gross estate for tax purposes if the donor dies while serving as custodian.
4) For educational financial aid purposes, these assets are considered the child’s and generally have a bigger impact on calculations for financial aid need.
Custodial Roth IRAs: Contributions can be made to a Roth IRA by or on behalf of a minor who is earning income, up to the current IRS maximum of $6,000 per year or the amount earned by the minor whichever is less.
1) Although the contributions are after-tax dollars, the gains grow tax deferred and can be distributed tax free after age 59½ if the IRA has been established for at least five years. (A $6,000 contribution earning 6 percent compound return would grow to a little more than $82,000 in 45 years, meaning $76,000 would be distributed tax free.)
2) There are no age restrictions for contributions to a custodial Roth IRA, only that the child must have earned income.
3) This option could deliver a jumpstart to the minor’s retirement goal in a tax-efficient way.
4) Roth IRAs are not subject to minimum required distributions, so they can be left to grow tax free until the owner’s passing. Additionally, Roth assets can be left to beneficiaries federally tax free.
1) Roth IRAs are intended for retirement, and distributions taken before 59½ may face ordinary income taxes plus a 10 percent penalty on gains, though some exclusions apply.
2) As a custodial account, the assets become the child’s upon reaching the age of majority, which again varies by state from 18 to 21. Again, donors may have concerns about the financial responsibility of the child at that age.
An investment in a child’s future is a wonderful gift. But there are many factors and nuances to consider in deciding how to invest for minors. If you have funds you wish to give to the next generations, consult your financial advisor to determine the investment option that best fulfills your intentions.
The information included in this document is for general, informational purposes only. It does not contain any investment advice and does not address any individual facts and circumstances. As such, it cannot be relied on as providing any investment advice. If you would like investment advice regarding your specific facts and circumstances, please contact a qualified financial advisor.
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