With the Christmas holiday season upon us, no doubt you may splurge a bit more this time of year. The National Retail Federation (NRF) projects Americans will spend an average of $616 billion this holiday season.
“A financial gift today can be the foundation to a more secure financial future, thanks to the power of compounding,” says Greg McBride, chief financial analyst for Bankrate.com.
While it may not be the latest toy, electronic gadget or favorite store gift card – a bequest that will provide for a loved one’s financial future is both a lasting and fiscally savvy choice. In addition to proactively helping them pay for a variety of potential needs and wants, you can also teach them how to take control of their financial future.
UGMA/UTMA Custodial Accounts
It’s never too early to open savings products that will grow with the child over the years. Investment options in a custodial account are practically unlimited and can be opened at any bank, brokerage firm or other financial institution.
Custodial accounts, established under the Uniform Gift to Minors Act or Uniform Transfer to Minors Act, can be opened for any minor under the custodian’s name and must be used for the benefit of the minor. Anyone can contribute as much they want to a custodial account and there are no income restrictions.
UGMA/UTMA accounts are fantastic instruments to use since they allow you to invest in savings accounts, CDs, U.S. Savings Bonds, mutual funds, stocks, money market accounts, and most any other type of investment. With a UTMA account, you can invest in any type of real or personal property.
The money in the custodial account is the minors once they reach legal age and can be used for anything.The age when a child can take control of the account and assets varies from 18 to 21 years of age – depending on your state laws.
Be aware the income of a custodial account is taxed to the child. This is an advantage, if the child pays tax at a lower rate than the parent. Investment income generated by account assets that exceed $1,000 is taxed at the minors tax rate if they have no earned income. Any investment income over $2,000 a year is generally taxed at the parent’s tax rate.
Because the custodial accounts are counted as a minors assets, it may impact the amount of financial aid the minor receives.
529 College Fund
Want your financial gift to go specifically towards education? Save on a tax-advantaged basis for tomorrow’s education by opening a 529 plan. All 50 states and the District of Columbia sponsor at least one type of 529 plan, although the structure of the program and investment options varies.
“529 plans come in two different flavors – prepaid tuition plans and college savings plans. In either case, funds are accumulated on a tax-advantaged basis and remain an asset of the account owner, not the beneficiary. This is favorable for both financial aid as well as account ownership and control,” says McBride.
You can open one for as little as $25 and name anyone as a beneficiary – a child, grandchild, relative, friend, and even yourself. Unlike UGMA/UTMA custodial accounts, the donor, not the beneficiary, is in charge of the account. That means the donor decides how and when their investment is used.
529 plan accounts can be used for both college and trade schools and can help offset your state income tax and save you a few dollars.
Total 529 contribution maximums are determined by each state and can be as high as $380,000, according to U.S. News & World Report. Federal law permits single taxpayers to contribute up to $14,000 in one year or make a lump-sum contribution of $70,000 to cover five years. Married couples may contribute as much as $28,000 per year or $140,000 as a lump sum.
The account beneficiary can also be changed to another family member with no penalty or taxes. If the funds are not used for education, then they can be withdrawn, but you will pay tax and face a 10% penalty on profits.
Savingforcollege.com has a list of 529 plans by name, state and type to consider. Consult your tax advisor to determine your state’s 529 federal and state tax benefits.
For older minors that have a job, consider an IRA to start building their retirement fund.
While Individual Retirement Accounts (IRAs) have long been a popular choice for adults who want to supplement their income in retirement, they also make great savings vehicles for children who can take advantage of time and the power of compounding.
Regardless of your child’s age, they can contribute to a custodial Traditional or Roth IRA as long as they have earned income from a job. As of 2014, the annual contribution limit is $5,500. Not all money in the account must be contributed by the child. The custodian can make contributions in order to help them save for retirement. However, you cannot contribute more to the custodial IRA than what the child earns.
As the custodian, you make the decisions on investment choices and when the money is withdrawn – until the child reaches adulthood. Keep in mind that once the child reaches adult age, they can remove any amount of the assets. Obviously, you will need to explain the penalties associated with early withdrawal if they hold a Traditional IRA.
Since most kids seldom earn enough money to benefit from the up-front tax deduction associated with Traditional IRAs, a Roth IRA is the more attractive option since it’s more flexible and you can withdrawal any contributions for any reason, without penalty.
Keep in mind if the child takes an early withdrawal, earnings could be subject to taxes and penalties of 10% – unless you meet some of the exceptions listed by the IRS. One of those exceptions is for higher education, but only if you extract less than the qualified education expense.
To learn more about the tax rules for children, refer to the IRS Publication 929, Tax Rules for Children and Dependents.
Consulting with a trusted financial advisor will help you determine the right gifting choice to invest in a more prosperous financial future for your young ones.
What type of financial gift are you considering giving this year?
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