Hush Lil Babies

As parents, one of the best gifts we can give our kids is a strong financial foundation. Investing early and consistently can set them up for success, whether it’s for college, a down payment on a home, or even starting a business down the road. But equally important is teaching them the value of investing, making smart financial decisions, and taking responsibility for their own financial future. We believe it’s just as essential to give our daughter a head start with our savings efforts as it is to empower her with the knowledge and tools to manage her wealth responsibly. And the best part? It’s easier than you might think!

When our daughter was born, her father and I knew we wanted to help her build a solid financial head start. We started by setting aside $500 a month in a 529 College Savings Plan. But after doing more research, we realized there are other fantastic options for long-term growth. In fact, we are now considering opening a UTMA/UGMA account in addition to her college fund.

Let’s break down the pros and cons of both accounts so you can decide which investment path, or combination of both, makes the most sense for you and your family.

529 College Savings Plan: The Traditional Route for College Savings

When we first decided to open a 529 plan, our goal was simple: save for college. This is a very popular and extremely easy way for parents to invest for their kids’ education, and there are some great tax benefits when used for education-related expenses.

Pros of a 529 Plan:

1. Tax-Free Growth: The earnings grow tax-free, and withdrawals are also tax-free when used for qualified educational expenses like tuition, books, or rent.
2. State Tax Benefits: Some states offer tax deductions or credits for 529 contributions.
3. Beneficiary Flexibility: If your child does not use the funds for college, you can easily transfer the 529 plan to another family member (like a sibling) without penalty.
4. Rollover to Roth IRA: You can roll over 529 funds into a Roth IRA for the beneficiary, up to $35,000 over their lifetime, provided the 529 account has been open for at least 15 years. This offers an additional way to grow the funds if they’re not used for education.

Cons of a 529 Plan:

• Penalties and Taxes on Non-Education Withdrawals: If your child does not go to college or does not use the funds for educational purposes, you’ll face a 10% penalty on the earnings (not the contributions) and taxes on any growth at your regular income tax rate. That means, if you decide to withdraw the money for something else, the cost can be significant.

How Much Could You Make with a 529 Plan?

It depends on your risk level, but an age-based portfolio is a common option for 529 plans. These portfolios automatically shift from riskier, stock-heavy investments when your child is young to more conservative, bond-heavy investments as they approach college age. Typically, these age-based portfolios return 5% to 7% annually on average.

Let’s say you contribute $500 a month for 18 years at a 6% annual return. Here’s an approximate breakdown:

• Total Contributions: $108,000
• Total Growth: $123,020 (assuming 6% growth)
• Future Value (before taxes): $231,020

Now, if you use the funds for something other than education, you’ll pay a 10% penalty on the earnings ($123,020), which equals $12,302. Then, you’ll pay taxes on the remaining earnings at your regular tax rate (let’s assume 22%):
$110,718 × 22% = $24,336.96. After taxes, the remaining growth is $86,380.04.

Add the original contributions back in:
$108,000 + $86,380.04 = $194,380.04.

So, if you withdraw for non-education purposes, you’d have $194,380.04 after taxes and penalties.

UTMA/UGMA Accounts: More Flexibility for Your Child’s Future

While the 529 plan is fantastic for college savings, we began to consider what would happen if our daughter didn’t attend college or if she wanted to use the money for something other than tuition. That’s when we started looking into UTMA/UGMA accounts, which provide more flexibility in how the funds can be spent.

A UTMA (Uniform Transfers to Minors Act) account is essentially a custodial account, where you can invest money in your child’s name. Once they reach adulthood (usually at age 18 or 21), they gain full control of the account, and the funds can be used for anything: a car, a home, a business, or even a gap year of travel.

Pros of a UTMA/UGMA Account:

1. Maximum Flexibility: The best part of a UTMA account is that there are no restrictions or penalties on how the money is spent. Unlike the 529 plan, you won’t face a 10% penalty if the funds are not used for education.
2. Potential for High Growth: Like the 529, you can invest in stocks, bonds, mutual funds, or ETFs, which typically earn a 6-10% return over the long term.

Cons of a UTMA/UGMA Account:

1. Tax Implications: Earnings (interest, dividends, capital gains) in the account are taxed each year. The first $1,250 in earnings is taxed at 0%, the next $1,250 is taxed at the child’s tax rate (usually 0-10%), but earnings above $2,500 are taxed at the parent’s tax rate (which could be 22% or higher).
2. Annual Tax Filing: If your child earns over $1,250 in a given year, you’ll have to file a tax return for them. This can be a bit of extra paperwork.
3. Control and Ownership: Unlike a 529 plan, which is owned by the parents and controlled by them, a UTMA account is in the child’s name. While this gives the child more flexibility once they reach the age of majority (usually 18 or 21), it could lead to the child using the funds in ways the parents may not have intended.

How Much Could You Save with a UTMA/UGMA Account?

Let’s use the same example of contributing $500 a month for 18 years at a 6% annual return.

• Total Contributions: $108,000
• Total Growth: $123,020 (assuming 6% growth)
• Future Value (before taxes): $231,020

However, due to the taxes on earnings, you’ll need to factor in tax payments over time. It’s difficult to predict exactly how much the taxes will be, but a reasonable estimate is about $17,000 over the 18-year period. So, after taxes, you would end up with approximately $214,020.

What Plan is Better and How We Are Moving Forward:

After careful consideration, we’ve decided to keep the 529 plan for its simplicity and the tax-free growth it offers for education expenses. The 529 plan remains the best option for dedicated college savings.

However, we also plan to open a UTMA account and contribute $250 a month to both accounts, with both growing to around $115k by the time our daughter turns 18. Based on contributing $500 into each account, if the 529 funds aren’t used for education, we would end up with about $19,639 less in the 529 (after taxes and penalties) compared to the UTMA account. The UTMA offers greater flexibility for long-term goals, and we could even let it grow until she turns 21, potentially for use after college or for other milestones.

That said, we recognize that the UTMA may not be for everyone. The main downside is the annual tax burden and the fact that your child gains full control of the funds at adulthood, which may not align with everyone’s goals.

Roth IRA for Kids: Teaching Financial Responsibility and Wealth Building

One of the most important lessons we want to teach our daughter is the value of hard work and how to manage money wisely. While we’re setting up long-term investments like the 529 plan and UTMA/UGMA account to ensure her financial future, we also want her to learn how to invest for herself and continue building wealth independently.

When our daughter is old enough to earn income, whether through a part-time job or entrepreneurial ventures, we plan to help her open a Roth IRA. This powerful tool allows her money to grow tax-free for retirement (or a future home) while teaching her the importance of investing and building wealth.

Starting early, even with small contributions, can lead to substantial wealth down the road. If she contributes $6,500 annually starting at age 16, with a 7% return, she could have over $1.3 million by age 60, completely tax-free!

Why a Roth IRA?

• Tax-Free Growth: The money grows tax-free, so it can compound over time without worrying about paying taxes on the gains.
• Empowering Your Child to Invest: By starting a Roth IRA early, she’ll learn the power of compound interest and how to make her money work for her.
• Flexibility for Future Goals: Roth IRAs are primarily for retirement, but contributions can be withdrawn tax- and penalty-free anytime, and earnings can sometimes be withdrawn without penalty for things like a first-time home purchase.

Bottom Line: Start Investing Now

The most important thing is to start. Whether you choose a 529 plan, a UTMA account, a Roth IRA, or a combination of all three, it’s never too early to begin saving for your child’s future. You don’t need to do everything at once; starting with a 529 plan for education expenses is the easiest way to begin.

Even small contributions over time can make a big difference in your child’s future financial success. Take the first step today to give them the financial head start they deserve.

Disclaimer: I am not a licensed financial advisor. The information provided is based on my personal experience and research, and is intended to help guide you as you explore investment options for your family. Please consult a professional advisor before making any financial decisions.