Consider a ROTH IRA
Most people don’t equate ROTH IRAs with kids, but they make ideal investment vehicles for them. They are best suited for those whose time horizon is long and the current tax rate is low, which aligns very well with children. Children have decades to allow their contributions to grow tax-free. This coupled with the fact that these contributions can be withdrawn tax and penalty-free at any time, make this a great tool. Kids of any age can contribute to a ROTH IRA, as long as they have earned income.
For example, they could be age 16 with a part-time job, age 10 with a lawn mowing job, or age three with a modeling job. A parent or other adult will need to open the custodial IRA, and annual contributions cannot exceed the lesser of their earned income or the contribution maximum (which is $6,000 in 2020).
ROTHs also offer flexibility that other savings vehicles don’t provide. If your child or grandchild decides not to attend college, the money contributed to the account can be used for other purposes such as a car purchase or down payment on a house. Money can be withdrawn at any time, however, distributions of investment earnings (money that was earned – not contributed) may be taxed as income, penalized with a 10% early distribution tax or both. As it stands now, there are a few exceptions. After the ROTH has been funded for five years, your child can take out up to $10,000 in earnings to buy a first home tax and penalty-free. They can also withdraw earnings for qualified education expenses that will be taxed as income but will be penalty-free.
Consider a 529 Plan
Another popular college savings vehicle for children and grandchildren due to the many benefits they have. Earnings on a 529 plan grow tax-free and can be withdrawn tax-free as long as they are used for qualified education expenses. The earlier contributions are made, the longer the education funds can grow. Although they are not tax-deductible for federal returns, they are tax-deductible for many state returns.
Gift tax rules apply to 529 plans ($15,000 per year/per individual). However, there is an option that allows the parent or grandparent to spread a $75,000 contribution over a five-year time period to a single beneficiary without triggering gift taxes or impacting their lifetime gift tax exemption.
Another benefit to 529 plans is flexibility. Say your child decides not to attend college, but another child or member of the family does. You can transfer the 529 over to this new beneficiary and no tax penalty is triggered. However, if you transfer the plan over to a non-family member, it is treated as a non-qualified withdrawal and both the 10% penalty and ordinary income tax applies.
Keep in mind, if you are contributing to your grandchild’s 529, it may affect your Medicaid eligibility if counted as an asset. It may also affect your grandchild’s financial aid eligibility since withdrawn money is seen as student income. There are ways around this issue. You can transfer ownership of the 529 to the child’s parents or you can wait until January of your grandchild’s sophomore year to begin withdrawing the funds. Since the information used for financial aid calculations is based on tax information from two years prior, by their sophomore year, the withdrawals won’t affect the Free Application for Federal Student Aid (FAFSA).
Consider a UTMA
Opening a custodial account such as a UTMA (Universal Transfers to Minors Act) allows for flexibility and control over investments. They are used to hold and protect assets for minors until they reach the age of majority in their state. Funds can be used for non-education related expenses should your child or grandchild decide not to attend college. You can give up to $15,000 per year without incurring federal gift tax. Because the assets are deemed the property of the minor, a certain amount of the investment income will go untaxed while an equal amount is taxed at the child’s tax rate, rather than the parent’s rate.
Keep in mind, these accounts are considered an asset of the child and are counted against financial aid. These accounts cannot be transferred like a 529 plan can.
Giving shares of stocks can be a lifelong lesson to pass on to your child or grandchild. You can select stocks that resonate with your child or grandchild such as Nike, Under Armour, Disney, etc. Dividend-paying stocks can demonstrate the power of investing as they can see the price fluctuations and accumulation of dividends over time without depositing any additional money.
If you hold the shares currently, you can gift them by contacting your institution and filling out the proper forms to re-title some of your holdings in the name of the gift recipient. You can also set up a direct stock purchase plan in their name by filling out a form and mailing in a check if necessary. Your child or grandchild would receive a statement showing the number of shares they own and can buy more by mailing in additional checks, having automatic withdrawals set up from their bank account or reinvesting any cash dividends.
Simply giving your child or grandchild cash can go a long way in teaching them the value of saving. The choice is placed in their hands, and they must make the decision to save or spend. Review their bank statements with them monthly so they can see the fluctuation in value, run through examples of how money can add up over time. Help them understand and visually see the financial impact of their choices both short-term and long-term.
If gifting money to an adult child, keep in mind the annual gift tax exclusion for 2020 is $15,000 per recipient per year. Above this annual amount, your gift counts against the lifetime estate tax limits.
Although banks no longer sell bonds at branches, the Treasury Department allows you to buy bonds. To give Series EE and Series I electronic bonds, the giver and recipient need to set up accounts on TreasuryDirect.gov. After you’ve held the bond in your account for five days, you can transfer it to the recipient. You can also buy Series I paper bonds when you file your tax return.
Adding Your Child as an Authorized User on Your Credit Card
Adding your child as an authorized user can help build their credit score and be in a better position down the road when they need to be extended financing for purchases such as a car or house. It can also position them to receive credit cards that offer reward perks when they are 18 and eligible to receive their own credit card.
Payments must still be made by the primary credit cardholder but those timely payments are reflected on the authorized user’s credit score.
Many credit card companies have minimum ages and other rules/restrictions so contacting your credit card company for more information is important before adding any new users.
Laying the foundation for good credit can go a long way in developing a healthy financial mindset.
The most powerful way to help your children and grandchildren with their financial future is the engage in frequent conversations with them. Discuss their goals (short-term and long-term) with them and help them prioritize. Share stories of your financial successes and failures to afford them the opportunity to learn from them. Use every-day purchases and scenarios as a mechanism for teaching them the value of saving, risk vs. reward, and needs vs. wants. Provide them with valuable financial rules of thumb such as placing a certain percentage of what you make into a savings account.
Discuss the realities of college costs. Share with them college debt should be limited to close to 1x expected income upon graduation so the loan can be comfortably paid off in ten years. Search colleges together to determine the out-of-pocket cost and financial aid opportunities. CollegeBoard.org provides information on the financial aid offered at different schools. Involve them in the filing of FAFSA forms so they become invested in and understand the process.
Sometimes the greatest ROI can be achieved through listening, providing guidance and engaging children in conversations.
Source: Kiplinger/ Forbes/ SmartAsset/ CNBC/ NerdWallet/ USA Today
© Geier Asset Management, Inc. February 2020. Thomas M. Geier, CPA, CFP ®, PFS is a Vice President of Geier Asset Management, Inc., a Registered Investment Advisor. The articles & opinions expressed in this material were gathered from a variety of sources, but are reviewed by Geier Asset Management, Inc. prior to its dissemination. All sources are believed to be reliable but do not constitute specific investment advice. The views expressed are those of the firm as of February 2020 and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of results, or investment advice. Any advice given is general in nature and investors must consider their own individual circumstances. In all cases, please contact your investment professional before making any investment choices. Geier Asset Management, Inc. is not responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.