You want to set your children up for financial success, but what’s the best way to do that if you have some extra money to set aside for them?

This article will give some insight into how to think about choosing the best savings method based on your goals.

Clarify Your Goal

You first need to clarify what you’re actually saving for and trying to accomplish. 

Do you want to put money away for college so that your kids will graduate with minimal student loan debt? Do you want to save some money to give them a head start after moving out? Or maybe you want to help them get a jump on retirement savings.

Saving for College

Many parents first and foremost want to help their children get through college. And rightfully so – graduating with little or no student loan debt can be a huge benefit for a 22 year old still figuring out what they want to do.

If this is you, check out this guide to picking the best college savings account. 529 accounts have become the most popular and typically most advantageous savings vehicle for college. But if you want to save for one of the other goals mentioned above, keep reading to learn about your options.

Custodial Roth IRA

If your goal is to help your kids start putting money away for long term savings, a Roth IRA can be a great tool.

Tax Impact

Since the money grows completely tax free, the compounding benefits can be huge with such a long time horizon.

The downside is you can only contribute up to the amount of earned income the child has. But if they earn money from babysitting, mowing lawns, or any part time job, you can contribute to the Roth IRA for them up to the amount of income they earned. You could also consider matching their own contributions to encourage them to save some of the money they are making as well.

Because of the tax advantages of the Roth IRA, earnings within the account cannot be withdrawn (in most cases) until age 59 ½ without having to pay penalties.

Financial Aid Impact

When it comes to applying for financial aid, Roth IRAs have no impact as long as the child doesn’t withdraw anything from the account.

Legal Ownership

At age 18 or 21 (depending on your state), the child will take full ownership of the account. So it’s important to educate them about the potential penalties incurred from early withdrawals.

Outside of a college savings account, a Roth IRA is one of the most effective ways to save for children. There are not only tax and financial aid benefits, but also the ability to teach your children about saving and investing with a wide range of investment options available.

Custodial Brokerage Accounts

A custodial brokerage account may be the way to go if you want your child to have access to the savings before retirement, but don’t want to be pigeon holed into using the funds for college.

Tax Impact

Beware that investment earnings within this type of account are subject to the “Kiddie Tax”, which is in place to ensure parents can’t transfer a significant amount of investment income to their children to be taxed at a lower rate.

This means that for 2023 the first $1,250 of unearned income (this could be dividends, interest, or capital gains), is taxed at 0%. The second $1,250 is taxed at the child’s tax rate. And anything over $2,500 of unearned income is taxed at the parents’ tax rate.

Financial Aid Impact

Custodial brokerage accounts have unfavorable financial aid treatment. They are considered assets of the child, which means 20% of the account balance is included in the calculation of your expected family contribution.

Legal ownership

Similar to a Custodial Roth IRA, the child takes full ownership of the account when they reach the age of majority in your state.
However, the brokerage account allows for more flexibility since there are no rules around when the funds can be withdrawn or what they can be used for.

A Brokerage Account in Your Name

If the child having legal ownership of the account at 18 or 21 concerns you, open a brokerage account in your own name. 

Earmark the account to be given to your child at some point in the future. They can still have the benefit of learning about saving and investing and watching their money grow. 

You can then gift the account to them when you’re ready.

Tax Impact

Earnings in accounts in your name will always be taxed at your tax rate.

Financial Aid Impact

Accounts in the parents’ name do count against you for financial aid purposes. But only up to 5.64% of the account balance factors into the calculation of your expected family contribution.

Legal ownership

Since the account is in your name, your child would only have legal rights to the money once you change ownership of the account over to them. If it ends up being a significant amount of money, be sure to consider gift tax rules and filing requirements. In 2023, a couple can gift up to $34,000 each year to a child without any consequences.

Final Thoughts

There are several options when it comes to saving for your kids. Take some time to think about what your goals truly are for the money.  And finally consider the variables of taxes, financial aid, and legal ownership of each option before making your decision.

Joe Calvetti is a CPA and the founder of Still River Financial Planning, a comprehensive, fee-only financial planning firm that specializes in working with young families and professionals. Click here to learn more about how we work with clients.

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Disclaimer: The information provided above is for educational purposes only and should not be considered financial, legal, or tax advice. You should consult with a professional for advice specific to your situation.