Saving for Your Child’s Future? Define That Future!
by Carrie Schwab-Pomerantz, CFP®, President, Charles Schwab Foundation; Senior Vice President, Schwab Community Services, Charles Schwab & Co., Inc.
March 17, 2010

Dear Carrie,

I would like to open a savings account or a Roth IRA for my 6-year-old son. What do you think?

—A Reader

Dear Reader,

Saving on behalf of your son is of course a great idea. And I’m sure a lot of other parents are trying to find their way through the maze of choices, so I thank you for the question. Here are some things to think about as you make your decision.

First, ask yourself, "What is my goal?" If it's as simple as teaching your son how to save, an old-fashioned savings account is a good place to start. The goal will be to have him experience the satisfaction of watching his balance grow.

But I suspect you're thinking bigger—that you want to start preparing him financially for later life. That usually means three possibilities: saving for college, saving for adulthood, or saving for retirement. Of course, these aren't mutually exclusive, but you'll want to consider different vehicles for each.

And before we go into different account types, recognize that any account you open for your minor child will be a custodial account. This means that it’s legally his money, even though it will have both your and your son's names on it. You control the money until he’s 18 or sometimes as old as 25 (depending on your state’s laws and your preference), but after that it’s his to do with as he pleases.

College savings/529 plan: For most parents, saving for college is priority #1, and 529 plans offer two very powerful incentives: First, money invested in 529 plans grows tax-free, and withdrawals, including investment gains and income, are tax-free when used for “qualified” expenses for college (tuition, room and board, books, etc.). Second, a 529 plan is considered an asset of the parents, which means there's less of an impact on financial aid than if the assets were in the name of he child.

You can invest quite a lot of money in a 529 plan; with roughly 12 years to go before your son will matriculate, you've got time to put that money to work. It pays to shop around. Some states offer 529 plans with additional tax incentives; some plans have better choices and/or lower expenses.

Brokerage account: Let’s say you want to start accumulating money for your son’s future in a more general way; a nest egg for when he leaves college, for example, or when he starts a family. In this case, consider opening a traditional brokerage account. You can give him up $13,000 each year ($26,000 for couples) without triggering gift taxes, and use the account to invest in essentially any kind of traded security or fund. But there are a few issues to be aware of: the so-called “kiddie tax,” the impact on college financial aid, and the fact that you lose control once he is no longer a minor.

Like any other brokerage account, a custodial brokerage account for your son will be taxable, but because he is a minor, the so-called “kiddie tax” rules apply. Under these rules, the first $950 in investment income is tax-free and the second $950 is taxed at his rate (presumably lower than yours). But after that, the income is taxed at your rate. (These rules have been toughened in the last few years to prevent parents from transferring large sums of money to their children in order to save on taxes.)

The impact on financial aid stems from the fact that when colleges determine aid eligibility, they'll assume that 20 percent of the child's assets are available for college. A 529 plan, on the other hand, is in your name and is considered a parental asset; only 5.64 percent of it is considered "up for grabs" in determining aid packages.

And finally, remember that once your son takes ownership of the money (sometime between the ages of 18 and 25), he can do whatever he wants with it.   So if you believe that the account will be large, and you want more control, instead consider a trust account.

Retirement account: As you indicate in your question, many parents want to start early to build wealth for their children's retirement, and this is a particularly good use of the Roth IRA. But any kind of IRA can only be funded with earned income, so your son probably won't be eligible at least until he's a teenager with a job and a W2 form.

When he does have earned income, however, a Roth IRA is clearly the way to go for retirement savings. Unless he makes a lot of money at a very young age, he will ultimately benefit more from the tax-free growth of a Roth IRA as compared to the initial deductibility of a traditional IRA. You can open a custodial Roth IRA on his behalf and deposit as much as he earns up to an annual limit of $5,000 (this amount will likely increase in the coming years). This a great way to start building wealth for his retirement, and he'll have a super-long time horizon even if he's still in college or just starting his job.

When I was a kid, saving typically meant either a piggy bank or a passbook savings account (I had both). But for today's kids, saving can also mean investing, and you have a wide range of choices. The right choice will depend on what you're saving for. Good luck.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction and investment strategy for his or her own particular situation. Data contained here is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

(0310-1714)