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SAVE FIRST FOR THE kids’ college or for your own retirement? Pundits generally recommend that parents put themselves first. But I’d argue the question demands a more nuanced answer. The tax code offers numerous tax-savings opportunities for families with dependent children—and those tax breaks shouldn’t be overlooked.
To be sure, for cash-strapped parents, the top two financial priorities should be building up an emergency fund and putting at least enough in their 401(k) or 403(b) to capture the full employer match. Already doing that? Instead of shoveling further money into retirement plans, consider whether you’d be better off exploiting these seven kid-related tax strategies:
1. A 529 plan is arguably the best tax-favored college savings account. The plans come in two flavors. Prepaid tuition plans allow you to buy credits toward the cost of particular colleges, effectively locking in current tuition rates. Meanwhile, 529 savings plans offer the opportunity to earn tax-free gains by investing in a menu of mutual funds. Note that 529 money is an asset that can affect financial aid eligibility.
Want flexibility? Think twice before opening a prepaid tuition plan. One friend funded a prepaid plan, but his kids later balked at all the in-state colleges covered by the plan. The go-to website to review all things 529 is SavingforCollege.com.
2. Like 529 plans, Coverdell education savings accounts offer tax-free growth to pay for qualified education expenses. Coverdells can also be used for primary and secondary schools—now also an option for 529s, thanks to 2017’s tax law.
The downside: Coverdells have a relatively modest $2,000 per year contribution limit, plus there are income limits on who can fund these accounts. We contributed to Coverdells for just a couple of years and used the money for high school costs, so our tax savings proved quite small. Today’s 529s are almost certainly a better alternative, because all families can contribute, no matter what their income, and you’re allowed to contribute substantial sums.
3. A custodial account, set up under your state’s Uniform Gifts or Transfers to Minors Act, offers parents the opportunity to save money in a child’s name. In 2019 and 2020, the first $1,100 of annual earnings are tax-free and the next $1,100 are taxed at the child’s rate. Earnings above $2,200, however, are taxed at the parents’ rate.
While custodial accounts can generate small amounts of tax-free income each year, they come with some serious drawbacks. The money becomes the child’s, typically at age 18 or 21, and the balance counts heavily against college financial aid eligibility. Some parents don’t tell their children about any custodial accounts, while others spend the money on behalf of the child prior to college—especially if the kid is an out-of-control teen. The maximum each parent can transfer to a child without triggering the tax gift is $15,000 in 2019 and 2020.
We funded modest custodial accounts for both kids and structured the investments to provide income below the threshold where taxes kicked in. That saved our family a few hundred dollars in taxes each year. We never used the custodial accounts for college expenses. Instead, our daughter’s account became a townhouse down payment, while our son’s account continues to grow.
4. Savings bonds can be cashed in tax-free if the bond owner uses the proceeds to pay qualified higher education expenses. The tax break phases out at higher income levels. Even if you’re likely to qualify, buying savings bonds to pay for college isn’t a great strategy, as new EE and I savings bonds pay low interest rates, though the rate on EE bonds becomes more attractive if you hold them for 20 years.
5. A trust is a way to transfer money and future investment earnings to children, while retaining some control over when and how the money is used. Problem is, trusts add complexity and cost, and they can be rendered unnecessary by future tax law changes. For these reasons, trusts are probably not the best savings option for cash-strapped families. One example of how trusts can go awry: I’m an eventual beneficiary of an outdated, generation-skipping trust from my grandparents. It’s mostly ended up as a vehicle to transfer small amounts of wealth to the trust manager, thanks to 50-plus years of annual fees.
6. Working parents can claim a tax credit for childcare expenses for kids under age 13. The credit provides a direct tax reduction for expenses of up to 35% of $3,000 for one child and $6,000 for two or more children, though the percentage drops as low as 20% at higher income levels. As an alternative, parents might be able to set up a flexible spending account, or FSA, through their employer. The maximum FSA contribution is $5,000 per year. Yes, setting up and managing the FSA is more work than simply claiming the tax credit. But you avoid federal income and payroll taxes on the money contributed, and perhaps state taxes as well.
Which will save you more in taxes, the childcare credit or the FSA? You’ll need to crunch the numbers, given your childcare costs and tax situation. If you’re strapped for cash, funding the FSA and then later reclaiming the money might seem like a short-term financial drain. But those with higher incomes will typically fare better with an FSA—assuming it’s offered by their employer.
Your employer may also offer an FSA for health care costs, which can be a great way to pay deductibles and copays for both you and your kids. Health care FSA contributions are limited to $2,750 in 2020. Think carefully about how much to contribute, because unspent money could be lost. We maxed out our health care FSA for many years to pay for both kids’ orthodontist costs.
7. When children become teens and start earning income, they become eligible to contribute to IRAs, including Roth IRAs. Probably nothing beats the return from funding a child’s Roth, which can potentially deliver 60 or 70 years of tax-free growth. All of our kids’ income from those initial years earning money found its way into Roth IRAs.
John Yeigh is an engineer with an MBA in finance. He retired in 2017 after 40 years in the oil industry, where he helped negotiate financial details for multi-billion-dollar international projects. His previous articles include 7,000 Days, Window Dressing and Creeping Costs.
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I always caution, remember that every benefit comes with a price.
Most of the options you discuss come with significant fees, and taxable investments held long term may often be more tax-advantaged in the long run. This may reduce most of the value in the options you discuss (other than roth’s for teens) unless people are already in the top tax brackets.
In my mind, this is a natural reflection of who writes the bills–I assume mostly lobbyists and politicians.
Great intro. on transferring wealth to one’s children, thanks. I constantly read about the importance of minimizing mutual fund fees over the long-run, but rarely see any discussion about trust fees. They truly can become “a vehicle to transfer small amounts of wealth to the trust manager, thanks to 50-plus years of annual fees”. Vanguard (as usual) is one to consider when shopping fees.
I also did custodial accounts for my children, mainly because my Dad did the same for me. With the omniscience of hindsight, I’d do the Roth IRA that requires skin in the game from the child. It was entertaining breaking the law and not telling one of my children about the UGTM account until her early 30’s. I of course had to enlist the other children in the subterfuge. The money would have added unwanted leverage to some difficult stuff she was going through prior to that. When I told her about it I mentioned she could probably sue me and all I got was a hug. Your mileage may vary. 🙂
Our family trust was developed in the 1970’s (before Vanguard was Vanguard) with undoubtedly the best intentions, but unfortunately the idiot lawyer who set it up did not counsel on the potential consequences of as much as 70 years of locked-in management fees on a modest account. While an extended-period trust might be appropriate for disabled or out-of-control heirs, otherwise, I don’t believe locking things in for more than maybe a couple of decades as no one can can envision changes to our heirs, tax laws and global financial structures.