Most parents and grandparents I talk to have a desire to provide for the next generation. Many immediately ask about a 529 plan, but there are several other common account types that can be used to save for children and grandchildren. Some of these account types are often overlooked as a flexible way to both save for the next generation and prepare for your own future financial goals. The best way to save depends on the unique objectives of your family and the level of control you want to maintain over the money.
A 529 plan is an account type most have heard of. A tax-advantaged savings plan designed to encourage saving for future education expenses. Contributions to a 529 plan grow tax-free, and withdrawals are tax-free when used for qualified education expenses. The tax impact of a 529 plan is that there are no federal taxes on earnings and qualified withdrawals. Some states also offer tax deductions for contributions. However, withdrawals for non-qualified expenses may be subject to income tax and a 10% penalty. The impact on financial aid is that 529 plans are considered an asset of the account owner (usually the parent), which can affect the student’s eligibility for need-based financial aid.
The pros of a 529 plan include tax advantages, flexibility, and the ability to change beneficiaries. The cons include limitations on how funds can be used and potential penalties for non-qualified withdrawals. The SECURE Act 2.0 passed at the end of 2022 now allows for 529 plans that have been in existence for at least 15 years to be transferred to a Roth IRA in the beneficiary’s name. This limits some of the risk of paying a 10% penalty on earnings not used for education expenses. The transfer from 529 to Roth IRA is limited to annual contribution limits and subject to a $35,000 maximum per beneficiary.
Uniform Gifts to Minors Act (UGMA) And Uniform Transfers to Minors Act (UTMA) Accounts
These are custodial accounts that allow parents to transfer assets to their child, with the child assuming ownership of the assets at a specified age (usually 18 or 21). Sometimes parents have a fear of their children having control over this money at age 18 or 21. It provides parents an opportunity to have conversations with their children about the money held in the account, so they can hopefully make educated choices once they have control over the funds.
The tax impact is that the child is subject to the “kiddie tax” on any earnings over a certain amount, which can result in a higher tax rate than the parents would pay. However, once the child reaches the age of majority (18 or 21), they could potentially realize any gains on funds held in a UGMA/UTMA account at a lower tax bracket. This could be beneficial as the child is just starting out in their career and likely making less money. The impact on financial aid is that UGMA/UTMA accounts are considered the child’s asset. Assets that are the child’s have a greater impact on reducing the eligibility for needs based financial aid. The pros of UGMA/UTMA accounts include ease of use, flexibility, and no contribution limits. The cons include the tax impact and potential reduction in financial aid eligibility.
A Roth IRA is a retirement savings account that allows after-tax contributions to grow tax-free, with tax-free withdrawals in retirement. The impact on financial aid is that Roth IRA contributions are not considered in the financial aid formula, but withdrawals may be. The pros of a Roth IRA include tax-free growth and flexibility, with contributions able to be used for retirement or other purposes without penalty. The cons include contribution limits and potential penalties for non-qualified withdrawals.
Since contributions from a Roth IRA can always be withdrawn first without a penalty, this allows the Roth IRA to double as both a tax-free retirement account and a college savings account.
Taxable Brokerage Account
A taxable brokerage account is an investment account that allows you to buy and sell a variety of investments, such as stocks, bonds, ETFs, and mutual funds. Unlike retirement accounts such as IRAs and 401(k)s, which offer tax advantages, taxable brokerage accounts do not provide any special tax benefits. However, they do allow for favorable tax treatment on long-term capital gains.
When you buy and sell investments in a taxable brokerage account, you may be subject to capital gains taxes on any profits you earn. If you hold an investment for more than one year before selling, it is considered a long-term capital gain, which is taxed at a lower rate than short-term capital gains. If you sell an investment for less than you paid for it, you may be able to deduct the loss on your taxes. In addition to capital gains taxes, you may also be subject to taxes on any interest or dividends earned in your taxable brokerage account. Interest income is generally taxed at your ordinary income tax rate, while qualified dividends are taxed at the lower long-term capital gains rate.
The favorable tax treatment for long term capital gains potentially makes it a good option for balancing both future savings for the parents or using the proceeds to pay for college. Long-term capital gains are taxed at 0%, 15% or 20% depending on your taxable income. Capital gains may also be subject to state income tax.
Keep in mind that investing involves risk, including loss of principal invested. Individual investor results and tax ramifications will vary. You should carefully consider your own time horizon, goals, objectives and tolerance for risk before investing.
A Flexible Approach
The first two account types, a 529 and UGMA/UTMA, are used almost exclusively for education or for the child’s benefit alone. The second two account types, a Roth IRA and taxable brokerage account, can be good considerations toward both saving for the parent/grandparent’s own financial goals, with the added flexibility to use some or all of that money to provide for the children.
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This educational article does not offer or constitute – and should not be relied upon – as financial, investment, tax, or legal advice. Your unique needs, goals and circumstances require the individualized attention of your own financial, legal, and tax professionals as applicable, whose advice and services will prevail. Equitable Advisors, LLC and its associates and affiliates do not provide tax or legal advice or services.