How to Open a Tax-Free Account for Your Child

The U.S. tax code provides several avenues for building a child’s financial foundation with tax advantages. These accounts allow investments to grow without being diminished by annual taxes, and withdrawals for specific purposes can also be tax-free. The right account depends on the primary goal for the funds, whether for education, retirement, or general financial needs. Understanding the distinct rules and benefits of each option is key to maximizing these savings opportunities for a child’s future.

Education Savings Accounts

When the goal is funding education, two accounts offer tax benefits: 529 Plans and Coverdell Education Savings Accounts (ESAs). Both allow savings to grow and be withdrawn federally tax-free for approved educational expenses. However, they have different rules for contributions, income limits, and qualified spending, which may make one more suitable for a family’s needs.

529 Plans

A 529 plan is a state-sponsored savings plan designed for future education costs. Contributions grow federally tax-deferred, and withdrawals are tax-free when used for qualified education expenses. These plans have high contribution limits, often exceeding several hundred thousand dollars per beneficiary, and anyone can contribute regardless of their income. Many states also offer an income tax deduction or credit for contributions.

Qualified education expenses include tuition and fees at colleges, universities, and vocational schools. The definition also covers books, supplies, required equipment, computers, and internet access. If the student lives on campus, room and board are also covered. Expanded uses include up to $10,000 per year for K-12 tuition, apprenticeship program costs, and a $10,000 lifetime limit for repaying student loans for the beneficiary or their siblings.

An enhancement from the SECURE 2.0 Act allows for tax-free rollovers from a 529 plan to a Roth IRA for the beneficiary. This addresses concerns about leftover funds and is subject to a lifetime maximum of $35,000 and the annual Roth IRA contribution limit. To be eligible, the 529 account must be open for at least 15 years, and the funds being rolled over must have been in the account for at least five years.

Coverdell Education Savings Accounts (ESAs)

A Coverdell Education Savings Account (ESA) is another tax-advantaged vehicle for education savings with different rules than a 529 plan. The most significant distinction is the annual contribution limit, which is capped at $2,000 per year for each beneficiary. This limit applies across all Coverdell accounts for that child, so the combined total from all contributors cannot exceed $2,000.

Eligibility to contribute is restricted by income. For 2025, the ability to contribute phases out for single filers with a modified adjusted gross income (MAGI) between $95,000 and $110,000, and for joint filers with a MAGI between $190,000 and $220,000. Coverdell ESAs also offer more flexibility in investment choices than 529 plans, allowing for a wider range of stocks, bonds, and mutual funds.

Coverdell ESAs have a broader definition of qualified K-12 expenses than 529 plans, including tuition, fees, books, supplies, academic tutoring, and uniforms. Contributions must stop when the beneficiary turns 18. The funds must be used by age 30 to avoid taxes and penalties on the earnings.

Retirement Savings for a Child

Starting retirement savings early for a child can leverage decades of compound growth. The primary vehicle for this is a Custodial Roth IRA, which allows a minor to save for retirement with tax-free growth and withdrawals. Contributions are made with after-tax dollars, so the money is not taxed when withdrawn in retirement.

The Earned Income Requirement

A child must have earned income to be eligible for a Roth IRA. The IRS defines this as taxable wages, salaries, tips, or net earnings from self-employment; an allowance or cash gifts do not qualify. Legitimate income can come from a traditional W-2 job or from self-employment ventures like babysitting, mowing lawns, or dog walking. Clear records of self-employment income should be maintained to substantiate contributions.

A parent or guardian must open and manage the account as the custodian until the child reaches the age of majority in their state, usually 18 or 21. Control of the account is then transferred to the child. For 2025, the annual contribution limit is the lesser of the child’s total earned income for the year or $7,000. For example, if a child earns $3,000, their maximum contribution is $3,000.

How it Works

The main advantage of a Custodial Roth IRA is tax-free investment growth. When the child reaches retirement age (59½), they can withdraw all funds, including earnings, without paying federal income tax. This is beneficial for a child in a low or zero percent tax bracket, as contributions are taxed lightly, if at all, while future growth is never taxed.

Withdrawal rules provide flexibility. Contributions can be withdrawn by the custodian at any time, for any reason, free of taxes and penalties. Withdrawals of earnings before age 59½ are subject to income tax and a 10% penalty. Exceptions exist for certain expenses like a first-time home purchase or qualified education costs.

Other Tax-Advantaged Savings Options

Other options provide tax benefits for a child’s future, including custodial accounts under the UTMA/UGMA framework and U.S. Savings Bonds. These vehicles offer different degrees of tax efficiency and flexibility. Their tax implications differ from the tax-free nature of 529s and Roth IRAs.

Custodial Accounts (UTMA/UGMA)

Custodial accounts, established under the Uniform Transfers to Minors Act (UTMA) or Uniform Gifts to Minors Act (UGMA), are tax-advantaged, not tax-free. Assets in these accounts legally belong to the child but are managed by an adult custodian until the child reaches the age of majority. The “Kiddie Tax” applies to unearned income like interest, dividends, and capital gains generated by the investments.

The Kiddie Tax rules for 2025 create a tiered system for taxing this unearned income. The first $1,350 of a child’s unearned income is tax-free. The next $1,350 is taxed at the child’s marginal tax rate. Any unearned income exceeding $2,700 for the year is taxed at the parents’ marginal tax rate. These rules apply to dependent children under age 19 and full-time students under age 24.

U.S. Savings Bonds

Series EE and Series I savings bonds can offer tax-free savings when used for education. The interest earned can be excluded from federal income tax if the proceeds pay for qualified higher education expenses, which are limited to tuition and fees. The bond must be issued to an individual who was at least 24 years old at the time of issuance.

This tax exclusion is subject to income limitations in the year the bonds are redeemed. For 2025, the benefit phases out for taxpayers with a MAGI above $99,500 for single filers and $149,250 for married couples filing jointly. It is eliminated for single filers with a MAGI of $114,500 or more and joint filers with a MAGI of $179,250 or more. The bonds must be registered in the parent’s name, not the child’s.