What To Invest When You Are Expecting
By: Daniel Prichard
Expecting a child is often an extraordinarily overwhelming experience filled with joy, anticipation, and, inevitably, a bit of anxiety. For new parents, the journey through pregnancy and preparing for the arrival of a child involves navigating a steep learning curve and many unknowns. From understanding the intricacies of pregnancy and birth to grasping the essentials of newborn care, there's a wealth of new information to absorb at a breakneck pace. Amidst this flurry of preparation focused on immediate needs—such as setting up a nursery, choosing the right pediatrician, and understanding feeding and sleeping patterns—the financial future of the child can often become an overlooked aspect. Many parents find themselves so engrossed in the physical, logistical, and emotional preparations of welcoming a new baby that planning for the long-term financial future doesn't always receive the attention it deserves. Yet, establishing a financial plan early on is crucial and can have a lasting impact on the child’s life, helping to ensure that they have the financial resources they need to thrive.
Investing in your child's future is not merely about setting aside funds for their education or their initial steps into adulthood; it's about laying a foundation for their long-term financial success and fostering financial literacy from an early age. By beginning the investment process early, parents can leverage the transformative power of compound interest to maximize asset growth over their child’s youth. Remember, generational wealth is inherently tied to the next generation, so it is never too early to start thinking about securing your child’s financial future.
With this in mind, there are three types of investment accounts frequently considered by expecting parents: 529 savings plans, Uniform Transfers to Minors Act (UTMA) accounts, and Uniform Gifts to Minors Act (UGMA) accounts. While these accounts may seem confusing and overwhelming at first, this article aims to untangle the complex web of ownership, investment options, and tax implications to allow parents to make educated decisions that best fit their unique financial circumstances.
Overview of 529 Savings Plans and UTMA/UGMA Accounts:
To illustrate the differences in tax consequences and penalties, it is helpful to look at two simple examples:
Scenario 1: $10,000 is invested into a 529 savings account and into an UTMA account. Due to market growth over time, the value of these investments grows to $25,000 at which point the investments are sold to pay for college tuition. The tax consequences and penalties are as follows:
529 Account: Because tuition is a qualified educational expense, no taxes are paid on the $15,000 of realized gains (the difference between the initial investment value and the value it was sold). There are no penalties on qualified expenses. As a result, the full $25,000 of investment proceeds are applied to tuition.
UTMA Account: Because UTMA accounts are taxable, taxes must be paid on the $15,000 of realized gains. As a result, the amount applied to tuition is less than $25,000 due to the taxes on the capital gains.
Scenario 2: $10,000 is invested into a 529 savings account and into an UTMA account. Due to market growth over time, the value of these investments grows to $25,000 at which point the investments are sold to pay for a car. The tax consequences and penalties are as follows:
529 Account: Because a car is not a qualified educational expense, taxes are paid on the $15,000 of realized capital gains. Additionally, there will also be a 10% penalty on the $15,000 of earnings. As a result, the amount applied to the car is less than $25,000 due to the taxes on the capital gains AND the 10% penalty.
UTMA Account: Because UTMA accounts are taxable, taxes must be paid on the $15,000 of realized gains. As a result, the amount applied to the car is less than $25,000 due to the taxes on the capital gains.
Takeaways:
529 accounts only provide a tax advantage if used on educational expenses.
UTMA/UGMA accounts have the same tax consequences regardless of the use of funds (tuition vs a car).
UTMA/UGMA accounts can provide more value than 529 accounts for non-educational expenses due to the 10% penalty applied to 529 accounts.
Detailed Account Insights:
Additionally, each account type has specific benefits, requirements, and limitations.
529 Savings Accounts:
Qualified Expenses: College, graduate, and vocational school tuition and fees (uncapped); room and board, books and supplies, and computers, software, and internet services related to college only (uncapped); K-12 tuition and fees (capped at $10,000/year); student loan repayment (up to $10,000 lifetime).
Non-qualified Expenses: Any non-qualified withdrawals are subject to taxes and a 10% penalty.
Financial Aid Impact: 529 assets are considered parent assets (if the account is owned by the parent) not the child’s assets. As a result, FAFSA will only reduce eligibility for need-based financial aid by 5.64% of the value of the 529 assets.
Scholarship Flexibility: If the beneficiary receives a scholarship, the account owner can make a taxable withdrawal up to the value of the scholarship without triggering the 10% penalty.
Roth IRA Rollover: Starting in 2024, unused 529 assets can be rolled over into the 529 beneficiary’s Roth IRA account free of penalty. Rules include:
Lifetime limit of $35,000
529 account must be held for at least 15 years prior to rollover
Contributions made in the past 5 years are not eligible for rollover
Rollovers cannot exceed annual contribution limits ($7,000 in 2024 for individuals under age 50)
UTMA/UGMA Accounts:
“Kiddie Tax”: Tax law designed to prevent parents from shifting assets to their kid’s name to avoid taxes. Rules are as follows:
Applies to children 18 and under and dependent full-time students age 19-24
Unearned income (interest, dividends, capital gains) under $1,250 is not taxed
The following $1,250 is taxed at the child’s marginal tax rate
Unearned income over $2,500 is taxed at the parent/guardian’s tax rate
Tax Return Considerations: Parents can report their children’s unearned income on their tax returns (Form 8814) or the child can file their own taxes and report it on their own (Form 8615).
Financial Aid Impact: Because the assets are owned by the child, FAFSA will reduce eligibility for need-based financial aid by 20% of the value of the UTMA/UGMA assets.
Age of Majority: Varies by state, but typically between 18-21 years of age. Upon reaching the age of majority, the account owner gains complete legal control of assets. At this point a new brokerage account is typically opened in the name of the account owner and the assets are transferred in whole to the new account.
While each account type offers distinct benefits and considerations, it is important keep in mind that they are not mutually exclusive. Utilizing a strategic combination of account types can be part of a comprehensive approach to planning for your child's financial future. Whether you’re saving specifically for educational expenses through a 529 plan or providing broader financial support with an UTMA or UGMA, the key is to start the investment process early. Early planning maximizes the benefits of compound interest and sets the stage for a financially secure future for your child.
Disclaimer: This article is for informational purposes only and should not be considered financial or tax advice. Each individual’s financial situation is unique, and laws and regulations are subject to change. We recommend consulting with a qualified tax advisor or financial planning professional to discuss your specific circumstances and to ensure that you are making the best decisions based on the most current information
