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Tax Efficient Investments to Secure your Child’s Future

Written by Banks Editorial Team

Updated September 18, 2023​

4 min. read​

If you don’t want your kids strapped with a student loan, or you want to help them buy a car or a house when they grow up, it can be a good idea to look into tax-efficient investment accounts to save your kid’s future while also saving money on your taxes.

Investing in Your Children’s Future

The first step to a college saving plan is the same as the first step to any plan; you must address your current needs and ascertain your future needs. To reach a destination, you have to know where you are and where you are going. Only when you have a complete picture of the issue can you begin to solve it. So, let’s start the process by examining two simple realities. 

  1. Address current financial needs: The reality of your financial situation will be the most important factor in how you proceed. While you want the best for your child’s future, you shouldn’t sacrifice their present to get there. If you put aside more than you can afford to, the financial strain could end up doing more harm than good. This is especially true for investments that aren’t easy to draw money back out of should emergencies arise. So when you decided what you can afford to set aside, make sure to have a clear picture of how much you can spare while still leaving yourself a buffer for unexpected expenses. 
  2. Calculate the cost of going to college: The next reality you’ll need to determine is how much college will cost. The cost of going to college can vary wildly. There’s a significant difference in tuition between a local community college and an out-of-state Ivy League university. On average, students can expect to spend around $27,000 if they plan to go to an in-state public college and approximately $55,000 if they opt to go to an out-of-state private college. These estimates, provided by CollegeBoard, assume a four-year degree. Of course, students who choose to go for more advanced degrees will need to have more money set aside. Keep in mind that these are current prices. By the time your young one is ready to go off to college, they’ll likely be higher.

Tax Efficient Investments to Save For Your Children

There are a dizzying array of options out there for people who want to invest their money. Each of them has its upsides and downsides, and each is suited well to a particular purpose. Saving for college is a long-term investment, so most long-term investment strategies will work well for it, but which one is best for you? Do you need to be able to pull money out of the account in case something comes up? Let’s examine some of these questions as we look at the best tax-efficient investments to secure your child’s future. 

529 Investment Plans

A 529 investment plan is a special type of college savings account that lets you save money on taxes. As long as the money is in the account, you won’t have to pay any income tax on the earnings. Even once the money is pulled out of the account, it may be tax-free for qualifying educational expenses. This makes a 529 plan one of the best options for tax benefits. There are two types of 529 plans:

1. Prepaid Tuition Program

One of the things we said you should account for is college costs when your child is ready to attend compared to what they are now. If you’ve lived long enough to see inflation at work, this might be concerning to you. If it is, a prepaid tuition program is a good choice. Under these plans, you can begin saving up for tuition and lock in the price at today’s rates. This type of plan requires either a lump-sum payment for the tuition or an agreed-upon installment plan. 

2. College Savings Plan

Currently, there are only nine states that offer their residents access to prepaid tuition programs. The programs also cover tuition, leaving students to rely on financial aid to cover additional costs potentially. For those who can’t get a prepaid tuition plan in their state or want to cover more than just tuition, a 529 college savings plan may be the best college account to save on tax. You’ll see the same tax benefits but can use the money to cover a more extensive range of educational expenses. 

Custodial Account

When looking for the best college savings plan and alternatives to 529 plans, it’s also worth considering a custodial account. These also come in two forms: UTMA (Uniform Transfer to Minors Act) and UGMA (Uniform Gift to Minors Act). There are minor differences between the two; a UGMA is more limited regarding the type of assets you can put into it. But they share one thing in common, and that’s their custodial nature. Under a custodial account, the money does not belong to you. Instead, funds in a UGMA/UTMA belong to the child whose name the account is in. This means that you cannot spend the money on anything that isn’t for the child. Because money earned on the account is the child’s, there are tax benefits. If the amount earned is low enough, you’ll likely not have to pay any taxes. The rules vary from plan to plan and state to state, so it’s recommended to talk to a financial advisor to pick the right plan for your family.

Cash Exemptions

There’s an exemption in the federal gift tax for money used for tuition payments. So if you have a child who is already in school, you and other family members can gift them a certain amount, up to $15,000 per year at the time of this writing, without them having to pay taxes on it. This can be another effective way to help your child pay for their educational expenses in a tax-efficient manner. 

Roth IRA Accounts

A Roth IRA is similar to a 529 plan. Both investment vehicles accumulate their earnings without any tax being due until the money is withdrawn. They both also have qualified distributions that are entirely tax-free. For both of these, college tuition is a qualified distribution. However, contributions to a Roth IRA are more limited, so you’ll need to look at the limits that apply at your income level and decide whether that’s more or less than you’d like to contribute each year. 

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