Kids come with joy but also great responsibility. If you are financially savvy parents eager to start building a saving and investing plan for your babies when they are still young, what do you need to know? What kind of investment accounts can you open for your children? How do your children’s investment earnings get taxed? How can you strategically utilize tax benefits from your children?

In this article, we'll explore various investment accounts available for children and provide “hacks” for tax-smart financial planning.

1. 529 College Savings Plan: A 529 plan is an excellent investment tool designed specifically for educational expenses. Contributions to a 529 plan grow tax-free and qualified withdrawals for education-related costs are also tax-free. Take advantage of this account to save for your child's future education and research potential state tax benefits and matching programs to maximize your savings. You can even open this account and start saving and investing before your baby is born—just     name yourself as beneficiary until your child has a Social Security number and you can change the beneficiary to them.
2. Custodial Accounts (UTMA/UGMA): UTMA and UGMA accounts allow you to invest funds on behalf of your child. The account will become their own account when they reach the age of majority. Unlike 529 accounts, this account type can help fund your child’s other expenses beyond just educational (for example: down payment for their first home purchase later in life).

While the income generated from these accounts can taxable at the child’s tax rate as unearned income, be mindful of the "kiddie tax," which taxes unearned income received by a child under 18, or 24 if a full-time student, if above a certain threshold ($2,300 in 2023). Unearned income above this threshold will be taxed at the parent's or guardian's tax rate.

There are ways to hack taxes for the whole family if using this account effectively. Strategically allocate investments to minimize taxable income – like using investments that generate qualified dividends or long-term capital gains and using less investments that generate interest income. Or consider gifting assets with high gains to your child’s UTMA account, then sell them and realize the capital gains so that the gain can be taxed at the child's lower tax rate, rather than being subject to the higher tax rate that you typically have.

3. Coverdell Education Savings Account (ESA): A Coverdell ESA is another tax-advantaged account for education savings. Although contributions are not tax-deductible, the earnings grow tax-free and withdrawals for qualified education expenses are tax-free as well. With an annual contribution limit of $2,000 per child, this account can complement your overall education savings strategy.
4. Roth IRA for Kids: If your child has earned income, consider opening a Roth IRA for them. Contributions to a Roth IRA are made with after-tax dollars, but the growth and qualified withdrawals in retirement are tax-free. Encouraging your child to start saving early in a Roth IRA can provide them with a powerful tool for long-term wealth accumulation.

For example, if you have a small business and hire your child as a model for your website’s marketing, the income your child receives from this work is their earned income. Meanwhile, you have a small business expense for hiring this child model. The maximum annual contribution limit for a Roth IRA is the lesser of the earned income or the annual contribution limit set by the IRS (subject to change each year). For example, if your child earns $2,000 from their employment, they can contribute up to $2,000 to their Roth IRA for that tax year.

There is no minimum age requirement to contribute to a Roth IRA, but your child must have legitimate employment or self-employment income. The wages you pay your child must be reasonable and comparable to what you would pay an unrelated individual for the same work. It's important to document the work performed and maintain proper employment records to support the wages paid. While your child may have earned income, it's crucial to consider the tax implications. If your child's income exceeds a certain threshold, they may be required to file a tax return. However, if their income falls below the standard deduction amount(which is subject to change each year), they may not owe any federal income tax.

5. Use Child-Related Tax Credits to Plan for Optimal Tax Savings: Child tax credits can be a valuable financial resource for your family, providing assistance with the costs associated with raising children. There are several tax benefits associated with children and financial planning strategies that parents can utilize to     optimize their financial situation:

• Child Tax Credit: This credit provides a tax reduction for each qualifying child under 17. The credit amount and eligibility criteria may vary every year and depends on the state in which you live. It's important to review the specific rules on the IRS website or consult with a tax professional to determine your eligibility.
• Child and Dependent Care Credit: This credit allows parents to claim a portion of their childcare expenses as a tax credit. The credit is based on a percentage of qualifying childcare expenses, subject to certain limitations. If you're eligible for this credit, consider timing your childcare expenses strategically. For example, if you have flexibility in choosing when to incur these expenses, you may want to concentrate them in a year with higher income to maximize the credit.
• Education-related Tax Credits: The American opportunity tax credit and the lifetime learning credit can help offset the costs of higher education. If your child is pursuing higher education, explore the available education tax credits and choose the one that provides the greatest benefit. Compare the American opportunity tax credit, the lifetime learning credit, or any other education-related tax benefits to determine which one suits your situation best.

Although we are financial advisors and we help our clients with reviewing their tax returns, we are not tax professionals. Taxes can be complex, so please seek further guidance from a tax professional who can help you navigate the intricacies of child tax credits. They can offer personalized advice based on your specific situation and ensure that you're making the most advantageous decisions. Remember, it's crucial to comply with tax laws and regulations.

Happy planning!

Disclosures:

This information is presented for educational purposes only and should not be treated as tax advice. You should seek tax advice from your professional advisors before implementing any transactions and/or strategies regarding your finances.