What Is the Best Way to Save Money for a Child?

Education-Focused Savings Plans

Saving for a child’s educational future is a primary concern for many families, and several dedicated savings vehicles offer tax advantages. Among the most popular are 529 plans, state-sponsored investment vehicles. These plans offer tax benefits at the federal level, and often at the state level.

A 529 plan allows contributions to grow tax-deferred, and qualified withdrawals for education expenses are tax-free. Qualified education expenses include tuition, fees, books, supplies, and equipment for enrollment at eligible educational institutions, including colleges, universities, vocational schools, and K-12 schools (up to $10,000 annually for tuition). The account owner, usually a parent or grandparent, maintains control over the assets even after the beneficiary reaches adulthood.

Contributions to a 529 plan are made with after-tax dollars, with no federal tax deduction. However, some states offer a state income tax deduction or credit for contributions. Investment options within a 529 plan are managed portfolios, often age-based, which adjust asset allocation to become more conservative as the beneficiary approaches college age.

Withdrawals from a 529 plan are tax-free if used for qualified education expenses. Non-qualified withdrawals incur federal income tax and a 10% penalty on earnings. Rollovers between 529 plans and beneficiary changes are permitted, offering flexibility if a child does not pursue higher education or if funds remain.

A Coverdell Education Savings Account (ESA) is another education savings option. Unlike 529 plans, Coverdell ESAs have a lower annual contribution limit of $2,000 per beneficiary. This limit is an aggregate across all Coverdell ESAs for the same beneficiary.

Coverdell ESAs have income restrictions for contributors; individuals or couples with adjusted gross incomes above certain thresholds may not be eligible to contribute. For 2024, contributions phase out for single filers with modified adjusted gross income between $95,000 and $110,000, and for married couples filing jointly between $190,000 and $220,000. While 529 plans have no income limitations, Coverdell ESAs offer more investment flexibility.

Custodial Investment Accounts

Custodial investment accounts, established under the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA), allow saving and investing for a child’s future by transferring assets into their legal ownership. These accounts are opened in the child’s name, but a custodian, a parent or guardian, manages the assets until the child reaches the age of majority. The age of majority varies by state, ranging from 18 to 21 years.

Upon reaching the age of majority, the child gains control over assets held within the UGMA or UTMA account. Funds can be used for any purpose the child chooses, not solely for education, distinguishing them from education-specific plans. The custodian has a fiduciary duty to manage assets prudently in the minor’s best interest.

Assets contributed to UGMA/UTMA accounts become the irrevocable property of the minor. Funds cannot be reclaimed by the donor or custodian once placed into the account. Contributions are considered completed gifts and are subject to gift tax rules if they exceed the annual gift tax exclusion amount, which is $18,000 per donor per recipient in 2024.

These accounts can hold various assets, including cash, stocks, bonds, mutual funds, and real estate under UTMA. Investment earnings are subject to “kiddie tax” rules, where a portion of unearned income above a threshold is taxed at the parent’s marginal tax rate. 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 rate, and any unearned income over $2,600 is taxed at the parents’ rate.

Long-Term Savings and Investment Vehicles

Beyond education-focused and custodial accounts, other long-term savings and investment vehicles can build wealth for a child’s future. A Roth IRA is an option, particularly for children with earned income. A child must have earned income from employment, such as a part-time job or self-employment, to contribute.

Contributions to a Roth IRA are made with after-tax dollars, and the money grows tax-free. Qualified withdrawals in retirement are also tax-free. For 2024, the contribution limit is the lesser of the individual’s earned income or $7,000. For example, if a child earns $5,000 in a year, they can only contribute up to $5,000 to their Roth IRA.

A Roth IRA offers flexibility for early withdrawals for a child. While earnings cannot be withdrawn tax-free or penalty-free before age 59½, contributions can be withdrawn at any time without tax or penalty. After five years from the first contribution, earnings can be withdrawn penalty-free for qualified higher education expenses, though they may still be subject to income tax.

For low-risk options, U.S. Savings Bonds, such as Series EE and Series I bonds, offer a conservative approach. Series EE bonds are purchased at half their face value and accrue interest for 20 years before reaching full value. Series I bonds are inflation-indexed, with interest rates adjusting semi-annually based on inflation, protecting against purchasing power erosion.

These bonds are backed by the full faith and credit of the U.S. government, making them safe investments. While their growth potential is lower than market-based investments, they offer a guaranteed return and can be suitable for a portion of a child’s long-term, low-risk savings. Interest earned on savings bonds is exempt from state and local income taxes, and federal tax can be deferred until redeemed or mature.

Basic savings accounts and Certificates of Deposit (CDs) serve as simple savings tools. Savings accounts offer liquidity and a safe place to store funds, earning a modest interest rate. They are ideal for short-term goals or emergency funds, though their growth potential is limited due to low interest rates.

Certificates of Deposit offer higher interest rates than traditional savings accounts in exchange for locking up funds for a specified period, from a few months to several years. While CDs provide a predictable return and are insured by the Federal Deposit Insurance Corporation (FDIC) up to certain limits, their returns do not keep pace with inflation over the long term. These options are best suited for short-term savings goals or a conservative portion of a child’s financial portfolio.