^{By John Walker & William Beynon}

In my travels, I have yet to meet a person who wishes that their children and grandchildren do worse than they do in life.  Universally, I think that all parents want to give their children the best chance in life.  For many of the families that we partner with, that involves gifting to younger generations.  We have covered various tax aspects of gifting in prior posts (Walker, n.d.) but in this post, we want to look at two specific concepts – the minor’s Roth IRA, and the 529 Plan.  These are two very targeted gifting agendas, and while one serves to pay for education and the other helps to defray the costs of retirement, each has merit, and they are very related as it turns out.  Both have unique tax benefits that dovetail nicely with long-range growth and compounding.  We will begin with a few basics on each and then look at key strategies

STRATEGY ONE – 529 COLLEGE SAVINGS PLANS

529 Basics: Back in 1996, Florida Senator Bob Graham and Kentucky Senator Mitch McConnell led the bipartisan efforts to launch the creation of IRS section 529. Within the next few years, many states adopted their own plans (History of 529 Plans, n.d.). 529 plans are designed to be a tax-advantaged way to save for college. They generally come in two varieties:

Investing-based 529: The value of these plans is based on the securities inside of the plan. Generally speaking, these plans are invested in pooled groups as opposed to individual securities and may only be traded one time per year.  We will be focusing on this type of plan.
Prepaid Tuition Plans:  Just as the name indicates, these plans seek to protect from the risk of education inflation by purchasing future courses for current prices.

529 plans can typically be used by any school that accepts federal funding. There are trade schools, colleges, and specialty schools that accept this source. With recent changes, 529 plans may now be used for elementary school on up. Here is a link to the FASFA site to check on whether the school you are considering accepts 529: https://studentaid.gov/fafsa-app/FSCsearch

How it works: The basic function of the 529 is that you can deposit post-tax money and withdraw tax-free money if you follow the rules. This is the same basic function of the Roth IRA/401k. Depending on your state of residence you may qualify for a tax deduction from the state-level income tax for using your state’s plan. Florida does not have a state income tax, so we cannot enjoy this benefit. Here is a link to explore the currently acceptable uses of the 529 plan: https://www.savingforcollege.com/article/what-you-can-pay-for-with-a-529-plan.

529 plans have a special funding method that gives them broad appeal as well. These accounts can be funded by more than one person and have maximum limits that vary by state. (How Much You Can Contribute to a 529 Plan in 2024, n.d.). Many of the families that we help with these plans use annual exclusion gifts to fund these accounts. As a reminder, annual exclusion gifts are those below $18,000 in money or money’s worth of property. Such gifts require no reporting or tax to either the donor or the donee. The 529 can accept special advanced gifts of up to 5 years’ worth from any donor. You can only contribute cash to 529 plans. If you want to contribute other property, you may want to research the UTMA/UMGA plans.

Compounding and Tax benefits:

When utilized correctly, these accounts operate similarly to Roth IRAs. Post-tax money goes in, and Tax-Free money comes out. This ensures that when used correctly, your family retains and utilizes 100% of both the initial deposit and its growth. Few investments enjoy this benefit. We aim to highlight the importance of compounding and front-loading these plans. While every family has a limited budget, we emphasize the significance of acting promptly due to the time-sensitive nature of these investments.

Example: We will use 80% of the 50-year average of the SP 500. (CMT,2024). We will further use $5,000 as an annual contribution; The math is linear and could be used for any value. Our goal is to illustrate compounding and not to shoot for unreasonable returns.

Table 1

Table 2

In Table 1 (Various Lump Sums at Birth), the gifts occur at birth as a lump sum and compound until age 18. In Table 2 (Even Payments Over Time with Staggering Starts), the gifts commence at later and later birthdays and run while compounding to the 18th birthday of the child. We hope it’s clear that the sooner your family can start saving, the better. Time in the market is better than timing the markets as they say. It’s important to note that the $90,000 gift mentioned in Table 1 represents an advanced 5-year gift, totaling $18,000 annually over 5 years. This total sum equates to the same value as receiving $5,000 annually for 18 years. You can see that the compounding effect of the additional time matters. The front-loaded gift grows to more than double the gradual gift. The markets will not be as flat as is shown in the tables. We are all subject to the specific sequence of returns for the periods that we invest in the markets. This is where the argument for prepaid tuition roots itself. In a worse-than-average environment, prepaid plans can assure that your dollars spent now can be leveraged well in the future.

2024 Changes to the 529 Plan

Among the many changes that are coming along with the SECURE ACT 2.0, the 529 plan has now started to solve a tough question. “What if we don’t use all of the money we saved?” Historically there have been a few answers to this question such as:

• Change the beneficiary to another close family member and use it for them.
• If the surplus was created due to scholarship it can be removed with no penalty.
• Pay tax the 10% penalty on unapproved expenses.

Now we have yet another option; a stellar option as well as a segue to our next section. You may now rollover the normal contribution rate of a Roth IRA from 529 to a Roth IRA owned by the beneficiary of the 529 plan. As we will illustrate below, the time value of these early contributions cannot be understated. There is a lifetime rollover amount of $35,000 (Rollovers from a 529 Plan to Roth IRA: What to Know, n.d.). So, depending on your family circumstances, you may end up with a combination of strategies if you save more than required for college.

Strategy 2 Minor’s Roth IRA

Minor’s Roth IRA Basics: I realize that many of you reading likely have Roth IRA/401k plans but here is a quick recap. In 1997 Delaware Senator William Roth suggested the opposite of the traditional IRA. (Roth IRA Basics: 11 Things You Must Know, n.d.) Instead of getting tax-advantaged entry into savings, we could pay tax on the contributions and get the tax advantages at the other end during retirement. So, one of the biggest values of the Roth IRA is that currently all growth and contributions may be removed tax-free after 5 years and reaching 59.5 years of age. There are a few caveats to these rules, but they are outside the scope of this article.

How it works: IRA’s run on wages. To use an IRA the beneficiary must have W-2 income. This can be a little challenging for those below the teenage years, but your CPA may have some clever ideas about income to minors such as employing them in the family business or others. For this article, we are going to assume that the minors start to file 1040s and have W-2 income at 16.

Minors may receive gifts while having both earned and unearned income (dividends, interest, and the like). So let’s say that you think ahead and want to front-load their retirement. You may open a Roth IRA on behalf of your wage-earning family. The real value here is that they can be a decade or better ahead of where most begin to save toward retirement. So, you could gift them the contribution into the IRA up to 100% of their wages. While the contribution limit as of this writing in 2024 is $7,000 for those below 50 years of age, the Roth cannot hold more than they make. So, if your hard-working family only earns $5,000 that is the limit that can be given into the plan. We will use an annual income of $5,000 for the illustrations. That is about $96 a week that your family needs to earn.

Compounding and Tax benefits

We plan to establish the same concept as listed above in the 529 segment. Early savings are important. Again, we will use 80% of the 50-year average of the S&P 500 so that we are using reasonable returns.

Here in the top table, we illustrate the compounded growth of a single $5,000 gift at the ages between 16 and 18.  The growth here between the gift and retirement age has a lot of leverage.  The difference in waiting those two years between 16 and 18 comes out to a compounded difference of over $34,000.  The same gift given just two years later makes quite an impact.

In the second table, we illustrate giving $5000 gifts annually. Three gifts were given at 16, 17, and 18.  Then two gifts were given at 17 and 18.  Finally, just one was given at 18.  Again, you can see that giving early and often really counts.  I would hazard a guess that few people would decline any of these gifts, but some deep thought and meaningful discussion should be had as you look to extend the financial reach of your family

Summary

Coming full circle, we started by saying that wanting your heirs to do better than you were able is a nearly universal truth. As with all investing, there are trade-offs to consider, and the unique facts and circumstances of every family. Given those facts and circumstances, each family should decide what they want their legacy to be used for. Did you struggle through getting college paid for? Were there formative lessons you learned from that you would like to see your heirs learn? Perhaps having that Roth safety net later has appeal. Did you feel the stress and anxiety of crippling student debt? Maybe you’d rather your heirs graduate without that stress. The 529 might be a great consideration. It takes time and massive pressure to turn coal into diamond, but no amount of pressure will force bread dough to rise. It needs time and the right environment to prove. There is no one perfect way to address saving for minors. As with most of the topics considered here in Wisdom in Wealth, we would love to engage you and your family in a discussion on this topic. Please reach out to us if this is a topic you might like to discuss.