by Sharon Wirth
Financial Tip: Opening an Account for Your Child
For many parents, the rising costs of college are a primary financial concern. Tuition, housing and school supplies are all a threat to the budget that has not been carefully planned out. Or maybe you are a grandparent, uncle or aunt wanting to help out the cherished little ones in your life. If so, what’s the best way to set aside money for children?
There are several options to choose from: Coverdell Educational Savings Accounts (ESAs), Section 529 Plans, and The Uniform Transfer to Minors Act (UTMA) custodial account.
Coverdell ESAs are one way to build an educational fund for your child and can be used for every level of education – not for just college. You can contribute up to $2,000 annually per child on an after-tax basis. This means that you don’t get to deduct the contributions like you would for a Traditional IRA, but the earnings grow tax-deferred and come out tax-free if distributed before age 30 for eligible education expenses.
Multiple individuals can contribute to the same child’s account provided the total for the year does not exceed $2,000 per child, and these contributions can continue up until the child turns 18 (or longer for special needs children). If the accumulated value of the account isn’t distributed by age 30 (except for special needs children), then it is required to be taken out and the earnings taxed as ordinary income with a 10 percent penalty.
Alternatively, it could be rolled into another Coverdell ESA account for a different family member. Coverdell ESA contributions are subject to AGI limitations. The full contribution is allowed for single filers with an AGI of $95,000 or less and for joint filers with an AGI of $190,000 or less. The allowable contributions are phased out and then disallowed for single filers with an AGI of $110,000 and above, or for joint filers with an AGI of $220,000 and above.
Section 529 Plans
Section 529 plans are state-administered plans that accomplish similar goals as the Coverdell ESA, but with key differences that allow more flexibility. There is no age limit and no AGI limit for making contributions. In addition, allowable annual contributions are much higher than the Coverdell ESA’s and vary depending on which state’s plan you are in (there is no limit for California plans, but you may have to file a gift tax return if you contribute more than $15,000 as a single filer or $30,000 as a joint filer). However, there is an aggregate contribution limit ($529,000 in California) at which point you can no longer contribute. The account will continue to grow tax-deferred and comes out tax-free when distributed for eligible education expenses, just like the Coverdell ESA. Also like the Coverdell ESA, you can use the funds for all levels of education, but there is a $10,000 annual withdrawal limit if used for elementary or secondary school (there is no limit for higher education withdrawals).
The UTMA Custodial Account
The UTMA custodial account has the greatest flexibility of all, as it does not even have to be used for educational expenses. The account remains under control of the designated custodian but is reported under the Social Security number of the child, so any earnings are taxed to the child. Unearned income in excess of $2,200 may be subject to the “kiddie tax” at the parents’ tax rate, while income below the threshold would be taxed at the child’s rate. Custodians with a UTMA account enjoy the flexibility of using the funds for a wide range of expenses to benefit the child: Anything including general use, education, or even birthday parties, music lessons and vacations. However, it cannot be used for the basic necessities of raising a child such as food, clothing and shelter. UTMA accounts terminate and transfer directly to the child upon reaching age 18-25, which varies by state.
Opening the right type of account for your child is an important decision and should be done with the guidance of your financial advisor. At Montgomery Taylor Wealth Management, our team is happy to help you navigate different options available and help you select the optimal portfolio for your unique situation, keeping you and your little ones happy and secure!