If you're reading this, congratulations! Raising a child is one of the most important jobs you'll ever have. No investment will be more powerful than that of your time.
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Having said that, let's focus on a secondary concern: how to make wise financial investments for a child's future.There's no "best" way to save money for a child, but there are five vehicles you can take advantage of: Roth IRAs, Coverdell education accounts, 529 plans, UGMA/UTMA accounts, and life insurance policies.
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We'll cover the basics, but first, here's a chart that gives the view from 30,000 feet of how they work.
Chart by author.
Let's dive into each of these.
Roths are a great investment vehicle not only for adults, but also for children. You can set up an account with any discount brokerage and contribute as much as $5,500 per year. The money isn't tax-deductible, but all of the growth and qualified distributions are-- paying for school, buying a first house, and, eventually, retiring.
Roths also offer considerableflexibility. As long as you follow rules against self-dealing investments, you can generally choose to invest your money in nearly any type of investment and have complete control over fees paid if you decide to use mutual funds or ETFs. After five years, you can also withdraw any and all principal (but not growth) whenever you want -- even if it's not for a qualified purchase. In essence, you can set this up as a college fund, but it can be used for medical emergencies or even buying a first house, too.
Coverdells are very similar to Roths. The money you put in -- up to $2,000 per year -- is not tax-deductible, but growth and distributions are. You can set up such an account at most online brokerages and have nearly complete control over where the money is invested.
Coverdells, however, must be spent on qualified education expenses, or there is a penalty to pay. The list of qualified expenses can include things like elementary, middle, or high school tuition, as well as secondary education. One key advantage is that there's no five-year waiting period to make distributions.
These odd-sounding terms refer to the Uniform Gift to Minors Act and Uniform Transfer to Minors Act. In essence, these are vehicles for passing on accumulated wealth to the next generation. While that makes them popular with wealthier families, just about anyone can benefit.
Like Roths and Coverdells, these accounts can be set up at many discount brokerages. You have complete control over where the money is invested, and growth is completely tax-free. You can also take the money out at any time, and for any reason.
But there are important caveats to the rest of the tax considerations. The money you put in is not tax-deductible. And in 2017, the first $1,050 in distributions are not taxed, while the next $1,050 are taxed at the child's -- presumably lower -- tax rate.
These plans can be awfully confusing. You can live in Texas but invest all of your money in Wisconsin's 529 plans. Some states offer tax-deductible contributions up to a limit, but only if you live in the state and are using said state's plan. And the investment options available range from excellent to truly awful.
To help you navigate the mess, I've written a detailed explanationof the best and worst plans available.The key advantage to 529s is that -- like Roths and Coverdells -- all growth and distributions are tax-free, given that they're used for qualified education expenses
Finally, we have what I would consider the most complicated of all ways to save money for a child: life insurance. If you buy any type of insurance beyond term, you can use that insurance as an investment vehicle. Once the balance of your investments gets big enough, you can take out an interest-free loan (in other words, one you don't have to pay back).
The key advantage, as far as children are concerned, is that under current laws,if you use any of this money to help pay for college, it doesn't show up on FASFA forms. That means you can game the system: have a good chunk of money to offer you child, while still getting the maximum allowable financial aid.
That said, I wouldn't suggest it -- and I speak from experience. Long before joining The Motley Fool, I did this, but the results have been underwhelming. Your money is invested in areas where the fees are onerous and the returns are sub-par.
So there you have it. The goal of using any of these five solutions is to create a situation where you get to spend more quality time with your children, and less time worrying about how to save for them.
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