What I Did Wrong Saving for Kids
For my wife and me, saving for our kids was always a priority.
We have three children (the smiling faces in the pic above), currently between 6 and 11 years old. We were both fortunate to leave college without a dime of debt, and it was important to us that our kids have the same opportunity.
Here is what we did, and what we would do differently if we were starting over today.
This is not advice. I’m not suggesting what seems “right” for us will make sense for others. Everyone’s situation is different. However, we work with a lot of families in this situation, so the topic comes up quite a bit.
Finally, this is not about financial aid or other ways to pay for college. My focus here is more about what we can do, or could have done, to proactively save.
What I think we got right
We started early, within the first six months of them being born. Compounding works best over long periods of time.
We made regular monthly investments, and we automated it. The amounts were small, but we were consistent. We never saw the money, so we never spent the money. It added up slowly at first, then more quickly over time. Consider this: regular monthly contributions of $100, earning 8% per year, would grow to over $48,000 in 18 years. Not too bad.
We paid attention to taxes. 529 accounts grow tax-deferred, and if spent on qualified education expenses, can be withdrawn tax-free. In custodial accounts, we used exchange-traded funds, or ETFs, and individual stocks. Both types of investments can be tax-efficient ways for long-term growth.
That’s it. That was our plan.
What I think we would do differently
This got a little longer than I intended, so here’s a summary:
Ditch custodial accounts for college savings
Fund 529s (to an extent)
Fund a joint account, in our (the parents) names, for flexibility
Plan on gifting (to an extent)
Ditch custodial accounts for college savings
If starting over today, I think we would scrap the custodial (UGMA/UTMA) accounts as a college savings option.
We would not use the custodial accounts for college savings for two main reasons. First, the assets no longer belong to us. They legally belong to the kids as soon as they are deposited into the account. If we were hoping financial aid would be part of the college plan, assets owned by the student are most harmful in that equation. But the main reason we would scrap the custodial accounts is more personal. We like the idea of being “fair.” In this case, fair means we want each of our three kids to have roughly the same amount available to them when they become adults. When our oldest was born, we opened a custodial brokerage account for him and started investing. His investments performed well. Too well, maybe. Now when we look at the balance of his account, we cringe a little, knowing we will want to square it up with the younger two kids at some point down the road.
Fund 529 accounts
We would still use 529 accounts. Some of the benefits include state tax deductions for contributions, tax-deferred growth of those investments, tax-free withdrawals if the money is used for qualified expenses, and the fees are typically very reasonable. All good things. The SECURE Act 2.0, passed in December 2022, gave us another reason to like 529 accounts. Parents used to wonder what happens to the 529 assets if the kids don’t need the money for college, fearing taxes and penalties on funds withdrawn for non-qualifying expenses. Maybe the kids will get scholarships or grants. Or maybe that 6-year old decides college isn’t for them. Thanks to SECURE 2.0, some of those unused 529 assets may be rolled into a Roth IRA to give the kids a great jump on retirement savings. We wrote more about that here. Of course, we could always just change beneficiaries on the 529, but that could create a conflict with our idea of being “fair.”
Side note: if we were interested in leaving a legacy, specifically in support of education for future generations, and we had the money to do it, we would consider over-funding 529s. Maybe by a lot. Many plans allow for $500,000 or more to be contributed to a 529 account for a single beneficiary. Unused funds can remain in the account, continuing to grow tax-deferred, to support education expenses for grandkids, great grandkids, etc. This can be a pretty cool way to leave a legacy.
Use a taxable brokerage for more flexibility
I really like taxable brokerage accounts. I would fund a brokerage account in my and my wife’s name and simply earmark it for the kids. Why? Brokerage accounts give us a ton of flexibility and, potentially, a great deal of tax efficiency. The money is still controlled by my wife and me. No penalties on withdrawals. No rules on how the money can be spent. We still have complete control. In essence, by opting for the brokerage account over more 529 assets, we would be trading away tax-deferral (and potentially tax-free withdrawals) for control and more flexibility. Investments like ETFs also give us a lot of control over the timing of our taxes, and the gains are likely to be taxed as capital gains (usually 15% or 20%). Plus, we might have been able to avoid the situation I described above, where one child has substantially more in their account than the others.
We would include gifting
We would plan to give to our kids. If investments within our taxable brokerage account perform well, our first option is to sell, pay any associated capital gains tax (again, usually 15% or 20% of the gain), and spend the after-tax process on things that benefit them. The second option is to give those appreciated securities to the kids. They would have the same cost basis, but up to $2,500 of unearned income in 2024, like investment income, would potentially be taxed at their lower rate. We would need to be aware of the Kiddie tax rules if our goal is to reduce the tax liability. And, once they reach age 24, that unearned income would be taxed at their rates rather than ours. Working with a CPA or tax preparer can help make sure those rules are followed, and we get the intended tax benefits.
Others may disagree with my plan and that’s fine. For my wife and me, the right decision may not have to be the best mathematical decision, and we’re ok with that. We might value some things (like having flexibility) more than others. But for parents wanting to think through options, hopefully sharing some of our experiences and the thought process behind the decisions can help.
Interested in talking more?
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