What Is the Best Way to Save for Your Child’s Future?

Saving for a child’s future involves careful planning and understanding various financial vehicles. Each option comes with specific tax implications, contribution rules, and flexibility levels. Choosing strategies aligned with individual family goals is important. Families often consider these savings avenues to cover future education expenses, provide a financial foundation, or facilitate other significant life events for their children.

529 Plans

529 plans are education savings plans sponsored by states, state agencies, or educational institutions. They offer tax advantages to encourage saving for future education costs. These plans are popular for their flexibility and potential for tax-free growth.

How 529 Plans Work

A 529 plan allows individuals to contribute after-tax money into an investment account for a designated beneficiary. The account owner maintains control of the funds. Contributions are considered completed gifts for tax purposes. Funds within the plan grow tax-deferred, and qualified withdrawals are entirely tax-free.

Tax Benefits of 529 Plans

Many states offer additional tax benefits, such as a state income tax deduction or credit for contributions. This benefit often applies only if contributing to the home state’s plan.

Qualified Expenses for 529 Plans

Qualified education expenses cover a broad range of costs at eligible educational institutions. These include tuition, fees, books, supplies, and equipment. Room and board also qualify if the student is enrolled at least half-time.

Up to $10,000 annually per student can be used for K-12 tuition at public, private, or religious schools. Other qualified expenses include:

• Computers, peripheral equipment, software, and internet access if used primarily by the beneficiary for educational purposes.
• Payments of principal and interest on qualified education loans, with a lifetime limit of $10,000 per beneficiary and each of their siblings.
• Costs associated with registered apprenticeship programs.

Changing Beneficiaries and Rollovers

Account owners can change the beneficiary of a 529 plan without tax consequences. The new beneficiary must be a qualifying family member of the original beneficiary. The Internal Revenue Service defines eligible family members broadly to include:

• Siblings
• Children
• Parents
• Spouses
• First cousins

This flexibility allows families to reallocate funds if a child receives scholarships or decides not to pursue higher education.

The SECURE 2.0 Act introduced an option to roll over up to $35,000 from a 529 plan into a beneficiary’s Roth IRA over their lifetime. This is subject to annual Roth IRA contribution limits. The 529 account must have been open for at least 15 years, and the funds being rolled over must have been in the account for at least five years. This provides an alternative for unused funds.

Impact on Financial Aid

Funds held in a parent-owned 529 plan are considered a parental asset for federal financial aid calculations. Generally, only a small percentage of parental assets, up to 5.64%, is factored into the Expected Family Contribution. This impact is often less significant than the tax benefits and growth potential offered by the plan.

Changes under the FAFSA Simplification Act, effective for the 2024-25 academic year, mean that 529 plans owned by grandparents or other relatives are no longer considered student assets. Withdrawals from these accounts also no longer count as student income. This previously could have had a more substantial impact on financial aid eligibility.

Withdrawals and Penalties

Withdrawals from a 529 plan are tax-free and penalty-free if used for qualified education expenses. If funds are withdrawn for non-qualified purposes, the earnings portion is subject to federal income tax and typically a 10% federal penalty tax. State income taxes and penalties may also apply.

Certain exceptions can waive the 10% federal penalty, even if the withdrawal is non-qualified. These exceptions include the beneficiary’s death or disability, or if the beneficiary receives a tax-free scholarship, up to the scholarship amount. The earnings portion, however, remains subject to income tax in these cases.

Custodial Accounts (UGMA/UTMA)

Custodial accounts, established under the Uniform Gifts to Minors Act or Uniform Transfers to Minors Act, allow adults to hold and manage assets on behalf of a minor. These accounts are simpler to set up than formal trusts.

How UGMA/UTMA Accounts Work

UGMA and UTMA accounts involve an irrevocable gift of assets to a minor. A custodian manages these assets until the child reaches the age of majority, typically 18 or 21, depending on state law. Once the child reaches this age, they gain full control over the assets without any restrictions on how the money can be used. UGMA accounts generally hold financial assets like cash, stocks, and mutual funds. UTMA accounts can hold a broader range of assets, including real estate and intellectual property.

Tax Implications of Custodial Accounts

Contributions to UGMA/UTMA accounts are made with after-tax dollars. Earnings generated by the investments within these accounts are taxable each year. A portion of the child’s unearned income is taxed at their own, typically lower, tax rate under “kiddie tax” rules. For 2025, the first $1,350 of unearned income is tax-free, and the next $1,350 is taxed at the child’s rate. Unearned income above $2,700 is taxed at the parent’s marginal tax rate.

Annual contributions to these accounts are subject to gift tax exclusions. For 2025, an individual can contribute up to $19,000 per recipient without incurring gift tax. Married couples can gift up to $38,000 per recipient. There are no overall contribution limits to the account itself.

Control and Usage of Funds

The custodian manages the assets in a UGMA/UTMA account for the minor’s benefit. Once the minor reaches the age of majority, they gain complete control and can use the funds for any purpose. This lack of control for the original donor after the age of majority is a significant difference compared to 529 plans.

For financial aid purposes, UGMA/UTMA accounts are considered assets owned by the student. This can have a more significant impact on financial aid eligibility compared to parent-owned 529 plans. Student assets are typically assessed at a higher percentage, around 20%, when calculating the Expected Family Contribution.

Roth IRAs for Child’s Future

While primarily retirement accounts, Roth IRAs offer a unique way to save for a child’s future, particularly for education expenses. This is due to their tax-free withdrawal rules for contributions and certain qualified distributions.

Eligibility and Contribution Limits

A child must have earned income to contribute to a Roth IRA. Contributions cannot exceed their earned income for the year. For 2025, the maximum contribution limit for individuals under age 50 is $7,000. This limit applies across all Roth and traditional IRAs an individual holds.

Income limitations also apply to contributors. For 2025, single filers must have a Modified Adjusted Gross Income (MAGI) under $150,000. Married couples filing jointly must be under $236,000 to make a full contribution.

Tax Advantages and Withdrawal Rules

Contributions to a Roth IRA are made with after-tax dollars, meaning they are not tax-deductible. However, qualified withdrawals, including both contributions and earnings, are entirely tax-free. Contributions can be withdrawn at any time, for any reason, without tax or penalty.

Earnings can be withdrawn tax-free and penalty-free if the account has been open for at least five years and the account holder is age 59½ or older, disabled, or deceased. For education expenses, Roth IRA earnings can be withdrawn tax-free and penalty-free even before age 59½, provided the five-year rule is met. These qualified education expenses align with those for 529 plans, including tuition, fees, books, supplies, and equipment. The flexibility of accessing contributions without penalty makes Roth IRAs an attractive option for some families.

Flexibility and Potential Drawbacks

A Roth IRA provides flexibility because unused funds can remain in the account and continue to grow tax-free for retirement, or be passed on to heirs. However, annual contribution limits are significantly lower than those for 529 plans, which can limit the total amount saved specifically for education.

Coverdell Education Savings Accounts (ESAs)

Coverdell ESAs are another tax-advantaged savings vehicle designed to help families pay for education expenses from kindergarten through college. They offer some unique features compared to 529 plans.

Contribution Limits and Eligibility

The total annual contribution limit for a Coverdell ESA is $2,000 per beneficiary, regardless of the number of contributors. Contributions are not tax-deductible. There are income limitations for contributors. For instance, in 2025, the ability to contribute is phased out for married couples filing jointly with a Modified Adjusted Gross Income (MAGI) between $190,000 and $220,000. For single filers, it’s between $95,000 and $110,000. The beneficiary must typically be under 18 when contributions are made, unless they are a special needs individual.

Qualified Expenses and Tax Treatment

Like 529 plans, earnings in a Coverdell ESA grow tax-deferred, and qualified withdrawals are tax-free. Qualified expenses for Coverdell ESAs are broader than for 529 plans for elementary and secondary education. They include:

• Tuition, fees, books, and supplies
• Academic tutoring
• Uniforms
• Transportation
• Supplementary items and services required by the school

For higher education, qualified expenses are similar to those for 529 plans, covering tuition, fees, books, supplies, and room and board.

If withdrawals are not used for qualified education expenses, the earnings portion is subject to ordinary income tax and a 10% federal penalty. The funds in a Coverdell ESA must generally be used by the time the beneficiary reaches age 30, or they are subject to taxes and penalties, unless rolled over to another eligible beneficiary.

Flexibility Compared to 529 Plans

Coverdell ESAs offer greater flexibility for K-12 expenses, covering a wider array of costs beyond just tuition. However, their much lower annual contribution limit of $2,000 per beneficiary significantly restricts the total amount that can be saved compared to 529 plans. Families can contribute to both a 529 plan and a Coverdell ESA for the same beneficiary in the same year.

Savings Bonds and Other Options

Beyond the more common dedicated education savings vehicles, other financial instruments can play a role in a child’s future financial security. These options may offer different benefits or serve different purposes.

U.S. Savings Bonds

Certain U.S. savings bonds, specifically Series EE and I bonds, can offer tax advantages when used for qualified higher education expenses. The interest earned on these bonds may be excluded from federal income tax if certain conditions are met. These conditions include using the proceeds for tuition and fees at an eligible educational institution and meeting specific income requirements in the year of redemption. This exclusion does not apply to state or local income taxes.

Trusts

Establishing a trust can be a method to provide for a child’s financial future, offering a high degree of control over how and when assets are distributed. A trust is a legal arrangement where a grantor transfers assets to a trustee, who then manages them for the benefit of designated beneficiaries, such as children. Trusts can be:

• Revocable, meaning they can be changed or canceled by the grantor.
• Irrevocable, offering greater asset protection but less flexibility.

Trusts can be customized to distribute funds at specific ages, for particular purposes, or to incentivize certain behaviors. They can also protect assets from creditors or lawsuits. While complex to establish and maintain, trusts can be useful for significant wealth transfers, for children with special needs, or when a high level of control over the assets’ use is desired.

General Investment Accounts

A standard taxable brokerage account can also be used to save for a child’s future. These accounts offer complete flexibility regarding how the money is used, without restrictions on qualified expenses. Contributions are not tax-deductible. Any investment gains, such as dividends or capital gains, are subject to taxes in the year they are realized. While lacking the tax advantages of dedicated education savings plans, general investment accounts provide liquidity and control over funds.

Considerations Beyond Specific Accounts

Saving for a child’s future extends beyond choosing an account type. Broader financial considerations such as inflation, investment strategy, and estate planning play a significant role in the long-term success of these savings.

Impact of Inflation

Inflation steadily erodes the purchasing power of money over time. For long-term savings goals like a child’s future education, considering inflation is important. What seems like a sufficient amount today may cover significantly less in 10 or 15 years. Investment strategies should aim for returns that outpace the rate of inflation to maintain or grow the real value of savings.

Investment Strategies and Risk Tolerance

The investment strategy chosen for a child’s savings account should align with the family’s risk tolerance and the timeline until the funds are needed. For younger children, a more aggressive investment approach with a higher allocation to equities might be suitable, given the longer time horizon to recover from market fluctuations. As the child approaches the age when funds will be used, a more conservative strategy, shifting towards less volatile assets like bonds or cash, is advisable to protect the accumulated principal. Many education savings plans offer age-based portfolios that automatically adjust the asset allocation over time.

Estate Planning Considerations

Integrating child savings into a comprehensive estate plan ensures that funds are managed and distributed according to parental wishes in unforeseen circumstances. This involves:

• Naming beneficiaries for accounts.
• Considering trusts for more complex situations.
• Understanding how different account types are treated in an estate.

Proper estate planning can help avoid probate, minimize potential taxes, and ensure a smooth transfer of assets for the child’s benefit.