To make sure your kids have some money when they start out their adult lives, you’ll want to start saving and investing for them when they are young. But what’s the best way to do that?
Start by deciding on an ownership structure.
In other words, whom do you want to own the investments? You or your children?
If you want to be the owner, you may want to set up a Section 529 plan.
All withdrawals will be free from federal income taxes, as long as the money is used for a qualified college or graduate school expense of the beneficiary you’ve named — typically, your child or grandchild. (The money will appear as income on the child’s tax return.)
This tax benefit is effective through 2010, unless extended by the U.S. Congress.
Withdrawals for expenses other than qualified education expenditures may be subject to federal, state and penalty taxes.
One of the biggest advantages of a Section 529 plan is that you own the account.
You decide who will get the money and when he or she will get it. You can even change the beneficiary to another family member.
Children as owners
If you want your children to own investments you’ve earmarked for them, you may want to establish either a custodial account or a Roth IRA. Let’s take a quick look at both:
Custodial accounts — You can set up a custodial account as established by either the Uniform Gift to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA).
This type of account may offer you some tax advantages. In an UGMA or UTMA account, the first $800 of investment income is tax-free to a child under 14, and the next $800 is taxed at the child’s rate.
Any amount over $1,600 will be taxed at your rate. After children reach 14, all their investment income is taxed at their rate.
You will have to balance the potential tax benefits of an UGMA/UTMA account against another factor: loss of ownership.
While your children are minors, you can still own the account, but once they reach the age of majority, the money is theirs to do with as they please and what they choose may not please you.
Roth IRA — A Roth IRA’s earnings grow tax-free, provided certain conditions are met.
Also, if you make withdrawals from a Roth IRA in the same tax year in which you contributed these dollars, your withdrawals are treated as non-events from a tax standpoint.
Keep in mind, though, that your children must have earned income if they are going to open a Roth IRA. Consequently, this type of account may be more suitable for children who are at least old enough to earn money.
See your tax adviser
Before you establish any account for your children — UTMA, UGMA, Section 529 plan or Roth IRA — consult with your tax adviser.
When it is time to make withdrawals from these plans, you may face unanticipated tax ramifications.
Start investing early
No matter what type of ownership arrangement or investment accounts you choose, start investing early.
Your children may want Power Rangers or Dora the Explorer dolls right now, but, before you know it, they’ll need college tuition, a car or a down payment on a home. Do what you can to be ready for those days.
Ross Hage is a licensed financial adviser with the firm of Edward Jones. For more information, call him at (928) 468-2281.