3 ways to save for your child's future

A prepaid tuition plan is an alternative to a 529 savings plan that may appeal to some parents. Designed for parents who are sure that their child will attend an in-state public school, this plan allows parents to simply purchase tuition credits in advance at a predetermined price.

Prepaid 529 plans retain the same tax, financial aid and parental protections as 529 college savings plans, but without being subject to ups and downs of the stock market.

"The major limitation to a prepaid plan is that if the child decides to go to school out of state, they'll get a return on their money, but they won't get the full value of the plan," says Parkin. "For example, if someone bought 1 year of tuition at a Kentucky state school for $12,000 and now tuition is up to $20,000, they would get a full year of college. If they decide to go to school in, say, Ohio, they would get a return -- probably $13,000 or $14,000 -- but they wouldn't get the full $20,000."

Like 529 college savings plans, prepaid plan holders can change beneficiaries at any time, but must pay a 10% penalty plus income tax on funds used for anything other than college tuition.

"You can have the prepaid plan to pay for tuition and a 529 college savings to pay for other expenses," says Parkin.

UGMA and UTMA accounts

If the child doesn't plan to attend college and therefore isn't at risk of losing financial aid, UGMA and UTMA custodial accounts offer decent tax breaks for children under the age of 18.

In these accounts, the 1st $1,000 in gains is tax-free, the 2nd $1,000 is taxed at the child's income tax rate and the remainder is taxed at the parent's income tax rate, according to the IRS. Plus, there are no restrictions on how the funds may be used as long as they directly benefit the child.

The downside of UGMA and UTMA accounts is that parents have less control over how the child eventually spends the money, says Michael Kay, a CFP professional and president of Financial Life Focus, a financial planning firm in Livingston, New Jersey.

"If money is in a UTMA or a UGMA account, it becomes (the beneficiary's) at the age of majority, which is 18 to 21, depending on the state," he says. "There's no legal way to prevent the child from using money that was intended for college or a house to go to Europe."

Roth IRA

Finally, parents can give their kids a financial head start by opening a Roth IRA in the child's name once the child starts earning income.

While children over the age of 18 retain control of the account, restrictions on Roth IRA withdrawals prevent investors from taking earnings out penalty-free until the age of 59 1/2.

However, there are exceptions to this rule that allow early withdrawals due to certain circumstances (hardships such as a disability) or for certain types of spending (such as purchasing a 1st home or for qualified education expenses).

A trust in the child's name is another option for parents concerned about how their kid will blow the dough. However, these plans come with legal and administrative fees parents won't encounter with a Roth IRA.

Common mistakes

Meanwhile, some parents may believe that it makes more sense not to save at all for their child's future. The idea is that having no college savings also means having no assets to assess.

However, that strategy may not work since even if parents don't save anything, they're still going to have an expected contribution once they fill out the FAFSA (Free Application for Federal Student Aid) form.

Another common mistake is for parents to save for their children's future before addressing their own long-term financial circumstances.

After all, most parents don't expect their children to fund their retirement.


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