529, Roth IRA or Brokerage Account for Kids?

[tschapira]

Dear TurboTax Community, 

I have a 2.5 year old and a 9 month old and I want to start a savings account for college. Between 529 (Illinois), Roth IRA, or a brokerage account, which one will provide the greatest return on investment?  What are your thoughts?

Also, should I open all three types of accounts for them and place 1/3 of the funds in each account?

[Hal_Al]

Q. Between 529, Roth IRA, a brokerage account, or custodial account, which is best?

A. Simple answer:  529 Plan also know as Qualified Tuition Plan.  It's the best tax advantages.  One drawback is that there can be a 10% penalty on earnings if the child decides not to go to college or trade school.  But the penalty can be avoided by naming another family member as beneficiary.  If the kid goes to school on scholarship, and doesn't need the 529 money,  the penalty (but not the tax) is waived.

There is no federal deduction for making a contribution to a 529 plan. Most states, including IL,  allow a deduction on the state return.

Q. Which one will provide the greatest return on investment? 

A. Although a 529 plan does give as many options as brokerage account, most of them have enough flexibility to give near the same returns as brokerage accounts.

As child must have earned income to open an IRA.  When used for education, the 10% penalty is waived, but tax is still due if the withdrawal is before age 59.5. 

[Opus 17]

"Also, should I open all three types of accounts for them and place 1/3 of the funds in each account?"

Your child can not have a Roth IRA in their name unless they have compensation earned from working.

With a qualified tuition plan, you can withdraw the earnings tax free if used for higher education.  You may get a state income tax deduction on contributions although you won't get a tax deduction from the federal government on contributions.

With a brokerage account, you need to start by learning the difference between putting the funds in the child's name (a bad idea) or a custodial account (better), and you need to understand that annual earnings will be taxed at your income tax rate, this is called the "kiddie tax" and it prevents you from putting money in a child's name and paying lower income tax rates because they have less total income than their parents. 

https://www.fidelity.com/learning-center/personal-finance/custodial-account-for-kids

https://www.irs.gov/taxtopics/tc553

With a brokerage account, the child is guaranteed to pay income tax when they withdraw the money, at capital gains tax rates which are currently lower than ordinary income (but might not stay that way).  With a QTP, qualified withdrawals are tax-free, while non-qualified withdrawals will be taxed as ordinary income (higher than capital gains rates) and may be subject to an additional penalty.

Whether to open a custodial investment account or a QTP depends on how much flexibility you want 18 years from now, and whether you want to pay some tax guaranteed, or maybe no tax or maybe higher taxes.   You could also hedge your bets and do both.

But no IRA. 

[AmeliesUncle]

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@Opus 17 wrote:

With a brokerage account, the child is guaranteed to pay income tax when they withdraw the money,

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No, the child would have "income" when the stocks/funds/bonds are sold.  "Income" and "pay income tax" are two different things.  And "sold" and "withdraw money" are also two very different things.

In upcoming years, the parent can be selling/trading in the brokerage account and realize up to $1100 of gains per year, tax free ($350 after the child gets a job).

[Opus 17]

@AmeliesUncle 

Your answer is not “no”, but “also”.  

It is almost certainly true that if the child withdraws money to pay tuition (the purpose of the taxpayer’s question), the child will owe capital gains tax on some amount of gains.  

It is also true that money held in a brokerage account will incur annual taxes for dividends, interest, and possibly capital gains, depending on what assets are held and traded.  And I agree that the first $1100 of any income generated annually will be tax free, with the rest taxable to the child.  

Ultimate point being, a 529 account grows tax-free and can be withdrawn tax-free for tuition, but there are limits and penalties if it is withdrawn for other reasons. A brokerage account will incur annual taxes and additional taxes when cashing out, but there are no rules or limitations governing how the money must be spent when it is cashed out.

[AmeliesUncle]

I still disagree with how you are stating it.  And you may also be assuming there is a large amount invested and/or large gains.

For example, year 1 the OP invests $10,000 in brokerage and buys Stock A.  Year 2, sells Stock A for a $900 gain and buys Stock B.  No "annual taxes" due.  Year 3, sells Stock B for a $800 gain and buys Stock C.  Again, no "annual taxes" due.  Year 4, sells Stock C for a $1000 gain and puts it into the 'cash' fund.  Again, no "annual taxes" due.  Year 5, withdrawn from 'cash' account.  No taxes for withdrawing it.

[Opus 17]

@AmeliesUncle 

Ok fine.  It might be a legal way to dabble in stocks without paying taxes, but that’s not how you save for your child’s college tuition.    

[AmeliesUncle]

Why not?  I don't understand why that would not be a great way to save for tuition, with the flexibility of using for something else and more investment options.

[Hal_Al]

@AmeliesUncle  said "The parent can be selling/trading in the brokerage account and realize up to $1100 of gains per year, gains per year, tax free".

Isn't it really $2200? (assuming the account is in the child's name or a custodial account).  The first $1100 is covered by the child's standard deduction and the 2nd $1100 is taxed at the child's tax rate (0% for long term gains, qualified dividends and capital gains distributions). 

@Opus 17 said "Dabble in stocks is not how you save for your child’s college tuition".   

@AmeliesUncle  said "Why Not?

The 529 plan has less risk and less hassle and nearly the same potential (thru mutual funds) .  A stock dabbling fool and his child's college money are soon parted. 

[Opus 17]

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@AmeliesUncle wrote:

Why not?  I don't understand why that would not be a great way to save for tuition, with the flexibility of using for something else and more investment options.

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Because you described a churning strategy of chasing short term gains.  

[AmeliesUncle]

Good point, it would be $2200, which would make it even better.

A 529 plan is usually just a limited amount of investment options.  Same risk as a brokerage.  But a brokerage gives you more options if you want it.

As I pointed out, both options can be tax free.  And as Opus pointed out, a 529 has potential tax and penalties if not used for education.  So I don't understand why you would choose a 529 before you do a brokerage.

[Hal_Al]

@tschapira  There's plenty of discussion available on the internet. Just "google" "529 plan vs custodial account" or similar wording.  Either way you're "betting on the come".