Creating a trust fund for your child or children is a terrific way to put away money and save for their future. It can be used to pay for college, provide living expenses during school, help pay for a new car or a first home, or even serve as a retirement plan before they even begin to work. No matter what purpose you use it for, a trust fund can be a powerful way to help your children financially for years to come.
Issues to Consider
There are a few issues to consider before you open a trust fund or begin investing for one. Two of the main issues involve taxes and risk.
For starters, when you open a trust fund for a child, there are no tax advantages for you. In other words, it’s not like a 401k or an IRA; you receive no tax break or pre-tax dollars or other deductions for the money you put into a trust fund. Plus, when you withdraw the money, it is taxed at normal rates.
As far as risk is concerned, investing always carries the prospect of losing money. Of course, there are ways to mitigate risk, including investments that do not pay much in return but are as safe as you can possibly get (like U.S. Treasurys). Still, the prospect of risk is there. Before you begin, you need to determine your risk profile, or how much risk you are willing to take on for your investments.
Later, I’ll discuss one potential option for you that can save money for your children’s college expenses while enjoying tax advantages.
Choosing the Right Investment
Once you decide to invest in a fund, it’s really a matter of selecting the type (or mix) of assets you want to make. You generally have three options:
- Stocks, bonds, and mutual funds
- Savings accounts and certificates of deposit
- Real estate investment trusts (REITs)
Stocks arguably offer the greatest return for the greatest risk. Bonds can offer lower returns but with more stability, especially if you choose U.S. Treasurys and municipal bonds. Mutual funds, particularly exchange-traded funds, offer a mixture of return and risk and are good for those who want moderate returns without going too far out on a limb.
Savings accounts offer very low return – in many cases, below 1% – but are generally reliable, particularly if you have an account with a well-known bank. Plus, savings accounts and certificates of deposit are insured by the FDIC. Also in this category are money market accounts, which offer higher interest rates than some CDs and savings accounts.
REITs are assets that are usually listed on public stock exchanges (if they’re public; some are private) and offer you the chance to invest in real estate without actually buying and holding property. These are useful for those who want to gain access to bigger returns off commercial real estate (the assets on which REITs are based) without being exposed to the risks of high corporate debt, liability, and major price volatility. Since the value of a REIT is based largely off rent paid by commercial tenants to the owners of commercial properties, you can get a fairly predictable income stream from these assets.
REITs are riskier than savings accounts, CDs, and money market accounts, but not quite as risky as stocks. U.S. Treasury bonds are the safest investments in the world and aren’t bad for long-term savings (since the longer the term, the higher the yield).
The 529 Plan
If you want to merely save for college while gaining tax benefits, you can do so through a 529 plan. This plan comes in two flavors: prepaid and savings. With a prepaid 529 plan, you can buy credits for tuition as they cost today and use them in the future, when tuition is likely to be more expensive.
Most people, though, use a savings plan, which lets you allocate money to certain assets based on the age of your child. You can use this money to pay for tuition, books, fees, equipment, and supplies, and also room and board if the student is enrolled as a half-time student or full-time student. This can’t go toward student loans or loan interest, though.
The tax benefit doesn’t come from the federal government, but from the state government. Most states offer tax deductions for state income tax for the 529 plan. Plus, contributions are tax-deferred, and any distributions that go toward qualified college expenses are free from federal taxes and state taxes, in most states.
Choosing the right investment, in the end, all depends on your risk profile and taxes. You also need to consider how much you will get in return for your investment. If you are beginning a long-term investment plan, you can afford to be more conservative because you have longer to build up enough money for your child to use. If you are starting late, being a bit more aggressive is okay in order to catch up.