Investing On Behalf of Your Children: What's the Best Investment?

By Carrie Schwab Pomerantz, chief strategist, consumer education, Charles Schwab

Parents and grandparents who are starting to put aside money for their children are faced with a myriad of choices as more financial institutions are working to make it easier and more affordable to get started.   Almost by definition, kids have a long-term time horizon, and some prudent investing when they're young should help them later in life, whether the assets go to higher education — one of the most significant forms of "investing" in their future — or become part of their financial safety net when they are adults.

Before opening any account for your children, you need to figure out what you're investing for and determine the best avenue to reach their goals.

SAVING FOR COLLEGE?

For the vast majority of parents, the daunting prospect of paying for college is what prompts them to start investing in a child's name. College costs have been increasing faster than the general level of inflation. If financing higher education is your goal, then your choice is pretty clear: Open a 529 plan for each of your kids.

When you invest in a 529 plan (held in your name with your child as the beneficiary), you’ll never pay tax on investment gains as long as the proceeds are used for qualified education expenses (tuition, room and board, computers and supplies, etc.). The plans are simple to open and manage, and most offer a variety of investment options.  Some will automatically adjust to a more conservative asset allocation as freshman year approaches. Some plans will allow you to change your investment choices easily, and others let you set up an automatic investment plan with small monthly or quarterly contributions.

Every state offers a 529 plan, and you are free to invest in any state's plan you like; your broker-dealer probably has a plan that will suit your needs. (Check on your state's plan first; some states offer state income tax deductibility.) And you can sock away a lot of money in a 529 plan: $200,000 (or sometimes more) per child over your lifetime and up to $60,000 in any single year without triggering a gift tax (if you don’t make another contribution for five years). Note also that some states offer 529 plans that allow you to prepay tuition, at today's rates, at that state's universities. But you'd have to be pretty confident you wanted your child to attend State U. in order to go this route.

The assets in the 529 plans are considered yours, which means they don't seriously impact your child's chance at financial aid. And if the child's grandparents or another relative or even a friend open the account, plan assets aren't included at all in most financial aid calculations. (So if your parents want to contribute, have them open a plan directly, not just give you a check. It's worth noting here that a grandparent or any other person can also pay tuition bills directly without triggering a gift tax, which can be a helpful estate-planning tactic.)

For the sake of completeness, I'll mention the other tax-advantaged college investing plan: Education Savings Accounts (ESAs), sometimes called Coverdell accounts. Like 529 plans, ESAs allow contributions to grow tax-free and be withdrawn tax-free for qualified education expenses. But eligibility is limited; for single parents, if your income is over $110,000, you can't open a Coverdell (joint filers can earn up to $220,000), and annual contributions cannot exceed $2,000. The only real advantage of ESAs is that they allow you to invest in virtually any listed security or fund, and they also can be used to pay for elementary and secondary school as well as college.

SAVING FOR SOMETHING ELSE?

The other primary type of account for minor children is the custodial account, a structure that has been around for many years (depending on your state, custodial accounts are referred to as "Uniform Gifts to Minors Act" or "Uniform Transfers to Minors Act" accounts). Assets in a custodial account belong irrevocably to the child, bear his or her Social Security number, and may require the child to file a tax return. You make the investment decisions — until the child comes of age (18 or 21, depending on your state's laws — although note that in some states, like California, a parent can designate the older age).

There is a slight tax benefit to UGMA/UTMA accounts; income and gains up to $850 for a child up to age 18 are generally untaxed, and the next $850 is typically taxed at the child's rate; if the account earns more than $1,700, income and gains are taxed the parent's rate. Another advantage of custodial accounts is their enormous flexibility when it comes to investment options: You can use them to buy any traded stock, bond, exchange-traded fund, or mutual fund.

But there are downsides to these accounts. Custodial accounts are considered the property of the child when it comes to financial aid, and any assets within those accounts will be earmarked at a much higher rate than 529 plan assets. Moreover — and this might be the biggest negative for many parents —because UGMA/UTMA assets belong to the child, he or she is free to do whatever he or she wants with them at the age of 18 or 21. Your child might use the money for college, but she might just decide to buy a Porsche instead.

THE BOTTOM LINE:

Saving and investing for your children's future is more than just a good idea, it’s also an opportunity to teach them about saving and investing. In addition, it's almost a necessity if your goal is, like most parents, to finance higher education. But building wealth for your children — and teaching them the basics of building wealth — is a priceless gift.

To read the entire article, please go to: 

http://www.schwab.com/public/schwab/research_strategies/market_insight/1/3/ask

_carrie.html?refid=P-1081933&refpid=P-994220

To learn more about college savings programs at Schwab, go to:

www.schwab.com/college

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