Best Ways to Save Money for Your Kids

Saving for a child’s future provides a foundation for their well-being. Early financial planning offers advantages, whether funds are for educational pursuits, a down payment on a home, or a head start into adulthood. Proactive saving allows funds to grow, contributing to a secure future.

Education-Specific Savings Accounts

For families focused on educational funding, specialized savings vehicles offer distinct tax advantages. Two prominent options are 529 Plans and Coverdell Education Savings Accounts (ESAs), each structured to support education-related expenses with varying features.

529 Plans are state-sponsored education savings programs for qualified education expenses. These plans typically come in two main types: prepaid tuition plans, which lock in future tuition rates, and education savings plans, which are tax-deferred investment accounts. Contributions are not federally tax-deductible, but many states offer tax incentives. Funds grow free from federal income tax, and withdrawals for qualified expenses are also tax-free.

Qualified education expenses for 529 plans include tuition, fees, books, supplies, and equipment for enrollment. Room and board expenses also qualify if the student is enrolled at least half-time, with limits tied to the institution’s cost of attendance. 529 plans can also cover up to $10,000 per year in K-12 tuition. For withdrawals made after July 4, 2025, other K-12 expenses, such as curriculum, books, tutoring, and testing fees, also qualify. Up to $10,000 in student loan repayments (per beneficiary and per sibling) and registered apprenticeship program costs are also qualified uses.

There are no federal income limits for contributing to a 529 plan, though contributions are subject to gift tax rules. An individual can contribute up to the annual gift tax exclusion amount, which is $18,000 per donee in 2024, without gift tax implications. Larger contributions can be made using a special election to treat up to five years of contributions as if they were made in a single year, allowing a lump sum of up to $90,000 in 2024 without gift tax. If withdrawals are not used for qualified education expenses, the earnings portion is subject to federal income tax and a 10% penalty. Account owners can change the designated beneficiary to another eligible family member without penalty.

Coverdell Education Savings Accounts (ESAs) offer tax-free growth and withdrawals for qualified education expenses. These accounts allow for contributions of up to $2,000 per year per beneficiary, regardless of the number of contributors. Eligibility to contribute to a Coverdell ESA is subject to income limitations. In 2024, the $2,000 contribution phases out for single filers with a modified adjusted gross income (MAGI) between $95,000 and $110,000, and for married couples filing jointly with a MAGI between $190,000 and $220,000.

Unlike 529 plans, Coverdell ESAs have age restrictions. Contributions must be made before the beneficiary turns 18, unless they are a special needs beneficiary. Funds must typically be used by age 30, or they are subject to taxes and penalties, though they can be rolled over to another eligible family member’s ESA. Qualified expenses for Coverdell ESAs are similar to 529 plans but also explicitly include expenses for elementary and secondary education, such as tuition, books, and supplies.

Custodial Investment Accounts

Custodial investment accounts, established under the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA), hold and manage assets for a minor until they reach the age of majority. These accounts are opened by an adult custodian, who manages investments for the minor, the legal owner. While UGMAs typically hold financial assets like cash and securities, UTMAs are broader, allowing a wider range of assets, including real estate and other personal property.

There are no specific IRS limits on UGMA or UTMA contributions. However, contributions are considered gifts and are subject to the annual gift tax exclusion. For 2024, an individual can contribute up to $18,000 per year per beneficiary without gift tax reporting. If contributions exceed this amount, the excess counts against the donor’s lifetime gift tax exemption.

UGMA/UTMA accounts are subject to “Kiddie Tax” rules. Income generated within these accounts, such as interest, dividends, and capital gains, is considered the minor’s unearned income. For 2024, the first $1,300 of a child’s unearned income is tax-free. The next $1,300 is taxed at the child’s tax rate. Any unearned income exceeding $2,600 is then taxed at the parents’ marginal income tax rate.

Contributions to UGMA/UTMA accounts are irrevocable, meaning assets legally belong to the minor and cannot be reclaimed. The custodian maintains control over the assets and their investment until the minor reaches the age of majority, which varies by state, typically between 18 and 21 years old, though some states allow UTMA custodianships to extend to age 25. Upon reaching this age, the minor gains full control over the assets and can use them for any purpose, which is a consideration for parents, as there is no guarantee the funds will be used for specific goals. These accounts can be opened through brokerage firms or banks.

Other Savings Vehicles

Beyond education-specific and custodial accounts, other methods exist for saving for a child’s future, each with unique characteristics and tax implications. These options can complement a comprehensive savings strategy, offering flexibility or specialized benefits depending on financial goals.

A Roth IRA for minors can be a long-term savings tool with tax advantages. A minor can contribute if they have earned income from employment, such as from a part-time job or self-employment. The annual contribution limit is the lesser of the minor’s earned income or the federal limit, which is $7,000 in 2024 and 2025. Contributions are made with after-tax dollars, and qualified withdrawals in retirement are entirely tax-free.

Roth IRA contributions can be withdrawn tax-free and penalty-free at any time, as they represent the principal invested. Additionally, earnings can be withdrawn penalty-free for qualified higher education expenses, even before the account holder reaches age 59½, provided the account has been open for at least five years. A custodial Roth IRA can be opened through most brokerage firms.

Establishing a trust for a minor can offer greater control over asset distribution or enhanced asset protection. A common type is a Section 2503(c) minor’s trust, which allows gifts to qualify for the annual gift tax exclusion while providing the grantor with control over the assets until the child reaches age 21. The trust principal and income can be distributed for the child’s benefit, or accumulated within the trust. Trusts offer a high degree of customization regarding how and when assets are distributed, valuable for complex financial situations or specific family objectives. However, setting up and maintaining a trust involves legal fees and ongoing administrative complexities, making them a more involved and expensive option compared to other savings vehicles.

A simpler approach uses a standard savings account or a non-custodial brokerage account held in the parent’s name. These accounts are straightforward to open and manage, with funds remaining under parental control. While offering ease of access and management, they do not provide the tax advantages of education-focused or retirement accounts. Any earnings in these accounts are taxed at the parent’s ordinary income or capital gains rates. Funds held in these accounts are considered parental assets for financial aid purposes, which can be favorable compared to assets held directly in a child’s name.

Navigating Withdrawals and Financial Aid

Understanding how saved funds impact eligibility for college financial aid and the process of making withdrawals is important for financial planning. Different savings vehicles are assessed differently when determining a student’s need-based financial aid, a factor that can influence the overall cost of higher education.

Assets held in parent-owned accounts, such as 529 plans and Coverdell ESAs, are treated favorably in financial aid calculations, especially for federal aid applications like the Free Application for Federal Student Aid (FAFSA). These assets are typically assessed at a lower rate, up to 5.64% of their value, when calculating the Student Aid Index (SAI), which determines a family’s eligibility for federal financial aid. This results in a modest impact on a student’s aid eligibility. Recent FAFSA simplification changes mean grandparent-owned 529 plan distributions are no longer reported as student income.

In contrast, assets held directly in a child’s name, such as UGMA/UTMA accounts or standard savings accounts owned by the student, are assessed at a higher rate, typically 20% of their value, when calculating the SAI. This higher assessment can reduce the amount of need-based financial aid a student might receive. The College Scholarship Service (CSS) Profile, used by many private colleges for institutional aid, may have different assessment methodologies, sometimes considering a broader range of assets. Strategic timing of withdrawals or considering asset ownership structures can help minimize the impact on financial aid eligibility.

The withdrawal process varies by account type. For 529 plans and Coverdell ESAs, withdrawals for qualified education expenses are tax-free and penalty-free. The account holder typically requests a distribution from the plan administrator, providing documentation if required; non-qualified withdrawals are subject to federal income tax and a 10% penalty on earnings. For UGMA/UTMA accounts, the custodian manages withdrawals for the minor’s benefit until the age of majority. Once the minor reaches this age, the custodian transfers control of the account and its assets to the adult beneficiary, who has full discretion over the funds.