I have two children. I started 401(k) accounts for their earned income, making money around the neighborhood. They usually only contribute a small amount per year since there is a threshold before a tax return is required. I have previously thought that this would be a better way to save in case they want to go to college or, in case they don’t, the funds could be used for other things besides education. Recently, they both expressed a desire to go to college, albeit they are still in elementary school. Should I consider a 529? What is the advantage of a 529 vs. a 401(k)?
It’s great that you are already interested in making plans for your children’s financial future, even at this young age. Just to clarify, a 401(k) is an employee-sponsored retirement account. Even though 401(k) plans get to set their own age threshold for contribution (typically 21 years), since your children are only in elementary school, it seems unlikely that they are employees of a company.
With that said, let’s say you actually opened an individual retirement account (IRA) for your children to contribute their earned income from work around the neighborhood, whether it’s selling lemonade or mowing lawns. Earned income, according to the IRS, is taxable money you make by working for yourself, your business, or someone else. And any investment or retirement account you start for your children will be considered a custodial account until they become old enough (usually 18 or older) to take over management of the account.
However, starting to save for retirement so early, combined with the power of compound interest, will help your children establish robust retirement savings as they grow older. But a retirement account won’t be the best vehicle to help your children save for their education. You should instead consider opening a 529 savings account. The advantage of a 529 savings account is that your children will be able to use the funds specifically for their education.
While you can withdraw money from a retirement account and use it for purposes other than just retirement, it’s widely discouraged because a withdrawal oftentimes triggers a tax penalty. You may be able to get around the 10% penalty if you use funds from an IRA for qualified higher education expenses, but that money should really be saved for retirement; it should be left in the account until your kids are old enough to withdraw the funds completely penalty-free.
If you want to save for your child’s future education, I’d recommend you set aside money in a 529 savings account for your children’s college. Each state has its own rules for 529 plans, so be sure to check your state’s rules for how much you’re allowed to contribute.
Broadly speaking, the maximum total contribution limits are fairly high, so add as much as you can afford to contribute until your children go to school, up to the total you think they’ll need. One downside to 529 plans is that they may have limited investment options and the money is not guaranteed to grow (remember, as with any investment, there comes some risk). Also, be sure to check if there are rules for in-state and out-of-state tuition.
You can also supplement a 529 account with a Coverdell ESA, also known as an education IRA. The money in this type of account can be withdrawn to help pay for education expenses now while your children are still young.
Best of all? If you open a 529 account for your children while also contributing to an IRA for them, they’ll have robust savings for both college and retirement, helping them be on the best possible financial footing come college graduation.
If you have questions about money, Kristin is here to help. Submit an anonymous question and she may answer it in a future column.
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