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Home » IRA's, Student Finances

Where Should you Put Money Gifted to your Children?

Last updated by on 15 Comments

A friend of mine recently asked me a great question that I’m guessing many parents run in to:

“What should you do with the money you receive for your child’s birthday or other special occasion? Currently we have ours sitting in savings accounts and are not doing anything with/for the kids funds.  Should we invest it for them?  If so how should we invest it?  Also should we try to steer the relatives away from checks and into something more beneficial for the kid like a 529 account, bonds, etc…?”

Well, my friend… I think you take that $50 and run on down to a local brewery to reward yourself for being a father and to support the local economy…

What’s that? You have a conscience, you say? Damn…

It’s an interesting question for a few reasons:

  • If your child is young enough, there is probably no use for the money for many years, maybe decades. You have to put it somewhere.
  • Due to the erosive effects of inflation, $100 today might be worth a fraction of that amount in 20 years, if not invested properly. Unfortunately, that means you have a bit of work ahead of you. Putting the money in a hole in the ground is not a solution.
  • Investment trading or buying fees can really cut in to returns, and going through the process of trading on random small gifts can be cumbersome.
  • Savings accounts and CD’s have earned paltry returns of around 1% for years and will for the foreseeable future. It’s better than throwing the gift in to a piggy jar for 20 years, but not by much.
  • Can you really ask a generous gifter, “Yeah, I’m going to need you to take this check back and return with a government bond instead, mmmkay?”?

Where to Put your Children’s Gift Money

I don’t have kids. But here’s my thought process:

Outside of maybe the grandparents who have made it known that they want to make a tradition or give a huge lump sum, I don’t think you really have much place to negotiate on what format the gift will come in. It just seems kind of unappreciative at best, tacky at worst.

And we’ve already concluded that keeping the cash in a hole in the ground in your back yard or in a hole in the ground at a bank is not really an option (at least until interest rates return to levels that aren’t murdered by inflation).

So that leaves you with a few options:

  1. money gift to childSet up a custodial IRA for the child and invest the money (note that child must have earned income in order to have an IRA).
  2. Set up a 529 Plan for the child’s education and invest the money.
  3. Set up a Coverdell Education Savings Account and invest the money.
  4. Invest the money in a custodial UGMA/UTMA account (non-tax advantaged)
  5. Invest the money in a long-term bond.

Let’s take out the last one. Bond yields really aren’t much better than the aforementioned bank yields at the moment. This may be a legit option down the road again, but right now, it’s a losing proposition.

So that leaves us with…

Custodial IRA vs. 529 Plan vs. Coverdell ESA vs. UGMA/UTMA Custodial Accounts for Gift Money

You may have noticed I have recently covered custodial IRA’s, UGMA/UTMA accounts, Coverdell’s, and 529 Plans in great detail.

That’s because I got the earlier question and didn’t have a good answer. My research led me to these four alternatives. And I don’t think there is one right or wrong answer as to which type of account is the best to put your child’s gifted money in.

So, I decided to put together the following chart to help you decide.

529 Prepaid Plan529 Savings PlanCoverdell ESA Custodial IRAUGMA/UTMA Account
What it is:Pay now for future education. Price of tuition is locked in at today's prices.Investment account for education savings. Withdrawals used by benefactor for education. Investments chosen by state.Self-directed investment account (similar to an IRA). Contribute & withdraw benefactors education costs.Basically a Roth or Traditional IRA for a minor, run by a custodian. Minor must have earned income to use.A non-IRA (non-retirement) investment account for minors, run by a custodian.
Maximum Annual Contribution:Varies by state plan, usually high.Varies by state plan, usually high.$2,000$5,500No limit, but $14,000 a year ($28,000 for a married couple filing jointly) w/o federal gift tax (2013).
Age Limit:Age limit variesNoneContributions stop at age 18. Must be used or transferred by age 30.None, custodian removed when owner is no longer a minor, per state law.None, custodian removed when owner is no longer a minor, per state law.
Income Limit on Contributions:No income limits for contributors.No income limits for contributors.Once your AGI is over $220,000 as a married couple or $110,000 for others, you can’t contribute (2013).Yes, see IRA income limits.No income limits for contributors.
Are Contributions Tax Deductible?Not tax deductible at federal level, but is deductible for some states. Not tax deductible at federal level, but is deductible for some states. Not tax deductible at state or federal level. Earnings & withdrawals are tax-free if used for qualified expenses.See tax advisorNo
When are Earnings Taxed or Not?N/AEarnings & withdrawals are tax-free if used for qualified expenses. Otherwise, tax/penalty applies.Earnings & withdrawals are tax-free if used for qualified expenses. Otherwise, tax/penalty applies.Taxed upon distribution (Roth is tax free) for Traditional IRA's or special exclusions. Early withdrawals subject to possible tax/penalty.Earnings are considered income and taxed annually.
Control of Withdrawals:
Account creator/ownerAccount creator/ownerAccount creator/ownerAnyone who is age of majority can be custodian until minor beneficiary reaches age of majority. Only beneficiary can withdraw.Anyone who is age of majority can be custodian until minor beneficiary reaches age of majority. Only beneficiary can withdraw.
Can be Used Towards (without penalty):Qualified post-secondary education expenses.Qualified post-secondary education expenses.Qualified primary, secondary, and post secondary education expenses.Qualified special exceptions or retirement (age 59.5).Can be used any time without penalty
Financial Aid Impact:Not considered student asset unless in beneficiary's name. Can increase child's potential financial aid because parents are expected to contribute only around 6% of their assets to finance college education, as opposed to the child's 35%.Not considered student asset unless in beneficiary's name. Can increase child's potential financial aid because parents are expected to contribute only around 6% of their assets to finance college education, as opposed to the child's 35%.Not considered student asset unless in beneficiary's name. Can increase child's potential financial aid because parents are expected to contribute only around 6% of their assets to finance college education, as opposed to the child's 35%.The taxable portion of a withdrawal for education is treated as income, which could impact financial aid.Beneficiary student asset. Can reduce financial aid.
Transfer of Beneficiary?YesTypically yes, but varies by state.Yes, beneficiary must be under age 30.Custodial status is lifted when beneficiary reaches age of majority. Owner can then change beneficiary at any time.UGMA/UTMA status is lifted when beneficiary reaches age of majority. Owner can then change beneficiary at any time.
Investment Options:No investments.Pre-determined by state.Self-directed.Self-directed.Self-directed.

If the Chart Doesn’t Help

If you’re looking for simple solutions and the chart doesn’t cut it for you, here’s how I would personally handle this:

  1. If I was saving for education, I would probably look towards my state’s 529 plan options.
  2. If I was not saving for education, I would probably look towards a custodial Roth IRA.

Children Gift Money Discussion:

  • Where do you place your children’s gift money? and why?
  • Have you run in to a scenario not highlighted here that a parent should think of or be concerned about?

About the Author
I am G.E. Miller, & this is my story. My goal is financial independence ASAP. If you share that goal, join me & 7,500+ others by getting FREE email updates. You'll also find every post by category & every post in order.


15 Comments »
  • KP says:

    Thanks GE. I was recently reading over the Custodial Roth article you wrote because this topic was on my mind. One of my closest family friends just had a baby and I was thinking of setting up an account for the baby. Is it something that I should run by the parents before doing? Is this a good idea as a “present”? I’m not sure if I want to direct it towards future education or just to have when the child turns 18. Maybe an IRA isn’t the way to go, and I should just open a non-retirement affiliated stock/mutual account…Any thoughts/ opinions to weigh in? Thanks for the post.

  • Are you sure it is possible to contribute to a custodial IRA for a minor if they do not have any earned income? I was under the impression that IRA contributions cannot exceed earned income for the year?

  • Natalie H says:

    I still like savings bonds. I’ve learned the hard way to keep the bond in your name with the minor as the beneficiary. I put some in my nephew’s name when he was born, but he has to have his own treasury direct account in order to redeem them. I will be responsible for any tax on the bond’s earnings for ones I put in my name, but that’s OK with me. I hope to gift the full amount I’ve put in every birthday and Christmas since birth somewhere between age 16 and 18 depending on maturity. I’ve done this for my own son and my two nephews (one of which is 9years old). When talking about amounts around $25-50 I still think savings bonds win. I couldn’t see opening one of these accounts you reviewed here with less than $1000.

  • Jake Erickson says:

    This is a nice breakdown. I tend to agree with you that any money we receive for our kids will probably go in a 529 account to be saved for college. Although, I think if we just get $25-$50 here or there we’ll probably buy the kid something because most likely that’s what the gifter wanted us to do.

  • Meredith says:

    My parents had saved for college for my sisters and I with mutual funds. I was able to get a partial scholarship and the military paid the rest of my tuition. What was nice about the mutual funds was that they were not tied to education, and that money could then be used for anything. There were no penalties for not using it on education. I used some of it to purchase a reliable car, for my wedding, and to boost my retirement and savings. Not every child will get scholarships or tuition money from the military, but that is something you will likely not know when you start saving. What is your opinion on this option?

    • G.E. Miller says:

      Mutual funds are an investment asset while the methods mentioned here are all investment accounts (assets fit within accounts). If they just bought mutual funds outside of one of these account types, they prob. paid significant taxes on them. If purchased within a 529 or Coverdell, it makes earnings tax free.

  • TC says:

    Great post, this had been weighing on my mind lately and with some of the more recent posts on custodial accounts I had hoped a comprehensive post comparing and contrasting them all would follow. I’m sure that friend of yours will enjoy a nice cold local brew (purchased with his own dime) while studying your chart.

  • Harvey says:

    Great post. I have just set up a retirement fund for my son in the UK. He is 5 months old! With tax breaks he may possibly be a millionaire on retirement, or at the very least will have a little more flexibility with what he spends his money on in his youth.

  • This is a fantastic breakdown. I plan to keep this as a reference for my future children as I wish my parents had this kind of information when I was a child but the internet wasnt what it is today.

  • Russell Kith says:

    Awesome post! I am bookmarking it and will probably share it on my site down the road!

  • Long says:

    I put my money gifted to my daughter into a 529 account. It’s not enough to pay for college, but it helps and she is a long way from college anyway. I anticipate that when she’s a little bit older and understands the concept of money she will have the opportunity to spend some of it as well.

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