There are many benefits to contributing early to education plans, IRAs, and 401k’s – the largest benefit being the advantage of time to compound funds in tax-advantaged accounts. Children have many years to grow the earnings in these funds, but how do you talk to your kids about the complex world of investing in these types of funds and encourage them to start early?
Let’s begin by discussing these different types of plans:
Section 529 Plans
A 529 plan is a tax-advantaged savings plan used to make it easier to save money for college, post-secondary training and tuition for elementary or secondary schools.
Originally, 529 plans were designed to be used for higher education expenses. In December 2017, the Tax Cuts and Jobs Act was passed, allowing 529 funds to also be used for private K-12 tuition, up to $10,000 in annual tuition expenses per year. Many, but not all, states follow the federal tax code; however, some may not consider K-12 a qualified education expense. See if your state is included here.
The money in a 529 plan may be used to pay for college expenses and K-12 tuition of the beneficiary. Contributions are made from after-tax dollars and earnings accumulated in a 529 plan are exempt from federal income tax. Distributions from a 529 plan used for qualified education expenses are tax-free. Distributions not used for qualified education expenses are subject to taxes and a 10% penalty, with certain exceptions.
Many states allow an income tax deduction or tax credit for contributions to the state’s (or other states’) 529 plan.
Contributions are limited to the amount necessary to provide for qualified education expenses of the beneficiary. There are potential gift tax consequences if your contributions, plus any other gifts, to one beneficiary exceed $15,000 for 2019.
There are no age limits or income phase-outs on contributions so anyone can contribute to a 529 plan and name anyone as a beneficiary. There is also no limit to the number of plans you can set up.
The purchaser of the account controls the funds until they are withdrawn, not the child. The purchaser can change the beneficiary to another if the child does not go to college or funds can be withdrawn by the purchaser at any time (although penalties will be incurred if funds are not used for qualified higher education expenses).
Children of any age can contribute to an IRA so long as they have earned income (taxable wages and/or income they earn from working or having their own business). If your child/grandchild earned money from mowing lawns, babysitting, dog walking or other small business ventures, they could be eligible to contribute to an IRA.
The maximum a child is able to contribute to an IRA in 2019 is the lesser of $6,000, or their taxable earnings for the year. If a child has no earnings, they cannot contribute to an IRA; an allowance and income on investment accounts do not count as earnings.
There are two types of IRA’s to which a child can contribute: Traditional and Roth. The difference between the two is basically when the tax is paid on the money contributed to the IRA.
- In a traditional IRA, tax is paid when the money is drawn during retirement. There are possible tax deductions for contributions to a traditional IRA, but most children do not earn enough money to benefit from the tax deduction associated with traditional IRAs.
- In a Roth, contributions are made with after-tax dollars; there is no deduction when contributions are made.
The money contributed grows tax-free in either type of IRA, but in a Roth, the tax benefit comes at retirement when there is no tax on distributions when the money is withdrawn (likely decades from now).
Section 401(k) is the section of the Internal Revenue Code allowing taxpayers to fund a retirement account through pre-tax payroll deductions.
Many companies offer some type of retirement plan for their employees to contribute as well as match the employee contributed funds up to a certain percentage. The account grows as interest, dividends, and capital gains are earned on these investments and the earnings are not taxed until disbursed at retirement.
Note that some employers offer a Roth 401(k) alternative as well.
Talking to the Kids
If you are familiar with the time value of money, you know that even small amounts invested can result in significant growth if compounded over long periods. What does this mean to kids?
A good place to begin is by explaining how compound interest works. Now, let’s use the child’s favorite candy to explain compounding. Give them a piece of their favorite candy. They can eat it now and it is gone, but if they save it until tomorrow, you will give them another piece. Tomorrow they will then have two pieces of candy. If they put those two pieces of candy aside, the next day you will give them two or three more pieces. This continues and by the end of the week, month or year, they have many more pieces of candy to enjoy. The more pieces they save, the more the sugary stash grows. They may soon realize the benefits of delayed gratification.
Although the key to compounding is to start early, it is never too late to start contributing! The Tax Warriors® at Drucker & Scaccetti have decades of experience assisting clients in planning for their children’s futures and are always prepared to help with this or any other tax-related matter.