Recently, my wife and I celebrated the birth of our son. Many of our friends have also recently had kids and, through casual conversation, I learned nobody really had good plans in place for saving for their children’s future. I am not talking about 529 Plans or other college savings plans; I am talking about putting away some money that can be used for anything in the future; be it their first car, their first house, braces or maybe even their first business.
Since we live in Washington State, we are taking advantage of at least two deals for young savers:
- BECU offers an APY of 6.17% on up to $500
- Watermark Credit Union offers an APY of 3% on up to $500
Using this method, my son will earn an average interest rate of approximately 4.6% per year on $1000 of very liquid money and, because his total unearned income is below $950, he won’t pay income taxes on the $46 or dollars of interest. Because it’s my son’s money, he will have $16 dollars more than I would have, even if I was able to match the interest rates, which is unlikely. This makes for a pretty good, albeit small, tax shelter for the average family.
Note: While the interest rate on the first $500 or so is usually good, the interest after that is typically pretty low. This means the compounding of interest earned on the $500 will be at a lower interest rate.
The deals I am taking advantage of are relatively small, but depending on what you are eligible for, there are other credit unions and banks offer the higher rate on larger sums of money. For example, if you work for Chevron or meet other membership criteria, the Chevron Credit Union offers:
- $25 initial deposit for newborns
- 7% on up the first $1000 in a MySavings account
- CFCU Youth Rewards, contests and more…
There are plenty of other youth account / kid’s accounts / early saver account deals out there. This site provides an excellent search tool. Some banks offer better than normal rates, and others offer other perks like sign up bonuses, reward programs and more, which (depending on the deal) could still make it worth it the effort.
Custodial Account – Advantages:
- You are putting money away for the child – Unlike 529 or other such savings methods, savings accounts have 100% flexibility and can be used for any purpose.
- It’s tax-free up to $950 in earnings – The money grows and earns interest federal tax free and you don’t even need to file a return for your child, so long as:
- The total unearned income (interest / dividends) is less than $950
- The child remains unmarried
- The child is under 19 or a full-time student under 24
Note: This assumes we are only talked about unearned income from Youth Savings Accounts, etc. If your child is earning income, there are other rules that dictate whether they need to file.
Important: Be sure to consult your tax adviser and the IRS to determine your individual tax advantages of this strategy.
- Between $950 and $1900 of earnings it’s only taxed at 10% – For returns above $950 the child is probably in a lower tax bracket than you (usually 10%) and thus the unearned income is still taxed at favorable rates.
- The child earns above market returns – Depending on the deal you find, the child can earn as much as 6, 7 or even 10% on between $500 and $1500 in various youth or early saver accounts.
- The money is safe – So long as you are taking advantage of a savings account at an FDIC or NCUA insured institution, the likelihood of you losing this money is exceptional low.
- You’re still in control (but) – Parents still have full control the money and the account until the child is 18 or 21 depending on the state. As long as you use the money “for the benefit of the child” you are in the clear.
- These accounts are usually free and include other goodies! – These accounts are usually free, have very low or no minimum balances, and sometimes include other goodies such as stickers, toys and bonuses designed to making “saving fun”.
Note: If the deal you find is not free, or has too many strings attached, it is probably not worth it. Be sure to read the fine print.
Custodial Account – Disadvantages:
- This takes time to set up and manage – Although the time is generally pretty minimal, for our $500 Early Saver account, the process took about 20 minutes (including drive time) and we expect it to ideally take no additional effort for the next 18 years. Because the account is for a minor, you may be required to show up in person. BECU for example does not let you create accounts online for persons under the age of 13.
- You are gifting the money – To take advantage of this plan, you are gifting the money to your kid. While you still have control, legally the monies must be spent only for the benefit of the child. In addition, there are possible tax implications, such as the $13k a year gift tax exemption that is reduced from your individual $1M life time exemption.
- Eventual Loss of Control: When your child no longer qualifies for the benefit, they also get full control of the money. Young adults might not make the best decisions with the money you have saved up for them.
- You may need to file a tax return for your child – Depending on how much you are gifting, and/or how much interest the child earns from that money, it may be necessary to file a tax return. The following IRS site has more details on rules for filing requirements for children with unearned income such as we have discussed above. Be sure to consult your own tax advisor.
- Beware of the “kiddie tax” – This tax is really designed to prevent the very wealthy from moving large amounts of assets to their children to avoid taxes. Unearned income that is earned by your child over $1,900 a year will fall under the kiddie tax and have to be carried over to your tax return and thus taxed at your tax rate. This basically means the “shelter effect” of this tax strategy is limited. You can read about a few gotchas of the kiddie tax here.
Regardless of the disadvantages, children’s accounts are still something to consider. Assuming you have the extra cash and the advantages outweigh the disadvantages, it is possible to scale this up. The following table shows the benefits of the above strategy assuming a gift of $26,000 put into a 2-year CD at 1.5% on January 1st, 2011:
In this example, the strategy saves $277.04 in federal income taxes. Assuming interest rates increase, you get a better CD deal, or you increase the amount gifted and took maximum advantage of this approach the results are even better:
This results in a theoretical maximum $570 in federal income taxes.