With costs rising across the board, many physicians wonder as to the best way to save for their child’s future. Parents should ask themselves: Do I want this money to go toward a specific goal? Do I want my children to have access to the funds all at once? Will my child manage this money responsibly? The answers to these questions can determine what account type to best direct the savings.
A common goal for many parents is to save for their children’s college educations. To assist with this, the IRS allows those who wish to save the ability to contribute to a 529 Plan. A 529 account is an investment account which provides favorable tax treatments if the money is used for qualified education expenses such as tuition, room and board, equipment, and/or student loan payments.
Money contributed to a 529 Plan can be invested in various mutual funds. These investments will (hopefully) grow as the child does, and provided withdrawals are taken to pay for a qualified education expense, the balance including the investment gain comes out of the account tax free. However, if money is withdrawn for a non-qualified reason, the account owner will need to include the investment gain in their income and pay ordinary income tax. In addition, non-qualified distributions are subject to a 10% penalty. Withdrawing money from a 529 for a non-qualified purpose can be very costly, but if used for the intended purpose of paying for education expenses, it can be a very useful savings tool.
What if your goal isn’t to save for college? What if your goal is to save for a down payment on a home, pay for a wedding, or just give your child a financial head start?
Before determining how to save, it is best to determine the level of control you want to retain over the account and its ultimate use. Parents who have a specific intended purpose in mind or are unsure their child will be responsible enough to manage the money in a sensible way, will want to make sure they or someone else controls how the money can be distributed. There are two primary ways to accomplish this. The first is to keep the money yourself. You control the assets and their distribution. However, depending on your estate planning goals, this may not distribute the assets as intended in the event of your death.
The other option is to create a trust. The primary motivation for establishing a trust fund is to create a vehicle that sets terms for the way assets are to be held, gathered, or distributed in the future. Common reasons for distribution often include health, education, maintenance, and support (HEMS), but can expand beyond these as well. The definitions of HEMS or other allowed distributions can be as strict or relaxed as you choose. Most trusts also create a timeline for when the beneficiary can access a greater portion or the full balance of the assets. Creating a trust ensures the assets are controlled until the recipient is deemed old enough or responsible enough to take over the money themselves.
If control is not a primary motivation, then custodial accounts can be opened. Commonly referred to as UTMA accounts, custodial accounts have lots of flexibility in terms of the assets that can be held and the types of expenses they can be used to pay . However, once the minor reaches the legal age of adulthood in their state of residence, control of the account officially transfers to the named beneficiary, and they claim full control and use of the funds.
Jeff Witz, CFP® welcomes readers’ questions. He can be reached at 800-883-8555 or at firstname.lastname@example.org.
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