A friend of mine recently asked me a great question that I’m guessing many parents think about at some point during their parenthood: “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? Why do you have to be so difficult?
Obviously, I’m joking. This is 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 CDs have earned paltry returns of less than 1% for years and will for the foreseeable future and funds placed there in recent years have lost value due to inflation. 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-sponsored inflation protected I-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:
- Set up a custodial IRA for the child and invest the money (note that child must have earned income in order to have an IRA).
- Set up a 529 Plan for the child’s education and invest the money.
- Set up a Coverdell Education Savings Account and invest the money.
- Invest the money in a custodial UGMA/UTMA account (non-tax advantaged)
- Invest the money in a long-term bond, like the aforementioned inflation protected I-bond.
Let’s set i-bonds aside. They are a great option for keeping up with inflation. However, they are not intended to outpace inflation. In 20 years, the value of i-bond investments will roughly have the same purchasing power as they do today. So, let’s take a look at the other highlighted options.
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 IRAs, UGMA/UTMA accounts, Coverdells, and 529 Plans in great detail. 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 Plan||529 Savings Plan||Coverdell ESA||Custodial IRA||UGMA/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 (in 2021 & 2022):||Varies by state plan, usually high.||Varies by state plan, usually high.||$2,000 (2021 & 2022)||$6,000 (2021 & 2022)||No limit, but $15,000 (2021) or $16,000 (2022) a year (2X for a married couple filing jointly) w/o federal gift tax.|
|Age Limit:||Age limit varies||None||Contributions 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 (in 2021 & 2022):||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 (2021 & 2022).||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 advisor||No|
|When are Earnings Taxed or Not?||N/A||Earnings & 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 IRAs or special exclusions. Early withdrawals subject to possible tax/penalty.||Earnings are considered income and taxed annually.|
|Control of Withdrawals:||Account creator/owner||Account creator/owner||Account creator/owner||Anyone 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?||Yes||Typically 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 solve it for you, here’s how I would personally handle this:
- If I was saving for education, I would probably look towards my state’s 529 plan options.
- 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?