Trump Accounts, 529s, and UTMAs: What’s the Best Way to Invest for Your Kids?

I’ve had a handful of parents and grandparents ask me about the new “Trump Accounts” (aka 530A accounts). Many are excited about the idea of giving their kids a head start financially, particularly the benefit of 60 years or more of compound interest. While the retirement math is pretty compelling, if the intent is for funds to be used in early adulthood, I think there are better tools available. 

If the funds are left alone until retirement age, compound interest works miracles. If a newborn child receives $5,000 at birth, and $5000 on their first birthday, at age 65, their account would be worth roughly $581,118 in today’s dollars, assuming historical rates of return. That’s after inflation. (In nominal, pre-inflation terms, the account would grow to something like $4.75 million. But it would have the purchasing power of $581,118 today.)

Another benefit is that kids born in the years 2025 through 2028 get a free $1000 contribution to their account when enrolled, with funds coming from the federal government as well as a number of large donors. 

Whether your child is eligible for the free contribution or not, you can contribute up to $5000 of your own money per year, per kid to these accounts. The only requirement is that your child is under 18 years old. Grandparents, friends, aunts, and uncles can contribute too, but the limit per year is $5000 total. 

No withdrawals are allowed until your kid is 18. And even then it functions like a pre-tax IRA, with the same early distribution penalties. There are certain exceptions for education and $10,000 toward a home purchase. In both cases, the account’s earnings are taxed as ordinary income, even if the penalty is waived. Therefore, I would think of this primarily as a retirement vehicle, given the availability of other tools to pursue other goals. 

Tax-wise, the money distributed from a Trump Account is taxed mostly as ordinary income, while the contributions are made with after-tax money. Unlike a pre-tax 401(k), you don't get a tax break for money going in, nor is the money tax-free coming out like with a Roth IRA. This is the price you pay for getting an extra decade-plus of compound interest inside a tax-deferred vehicle that discourages premature distributions.

A tax-deferred account means there are no taxes on dividends, interest, or capital gains received on investments in the account. You only pay taxes when the money comes out. Technically, the earnings portion is taxed as ordinary income, while the contributions are tax-free basis. But since you have a fixed dollar amount of basis—the initial $5,000 contribution—and 60 years of compounding, the account will most likely be something like 98% earnings and 2% basis. So roughly 98% of distributions would be taxed as ordinary income.

But what if you want to give money to a child to fund other priorities, earlier in life than retirement? 

Many people are familiar with 529 accounts (aka college savings plans). This money is after-tax going in, and tax-free on the way out, but only if used for education expenses. This is a great way to save for college, as the money grows tax-deferred (no taxes on interest, gains, or dividends). But if you want to use the funds for anything other than education, you’ll need to pay ordinary income taxes on the gains, plus a 10% penalty. That’s why the primary purpose of these accounts should be to fund educational expenses. 

There is one exception, however. Any funds not used for college can be used to fund Roth IRA contributions for your kid (though there are a few hurdles to clear for this option). 

• Hurdle one, the account must have been open more than 15 years. 

• Hurdle two, the funds used to make contributions must have been in the account for five or more years. 

• Hurdle three, your kid needs “earned income” for each year in which they want to make a contribution. This means income they received through a job or running their own business. 

• Hurdle four, they can only contribute $7500 per year (adjusted for inflation).

• Hurdle five, there is a lifetime maximum of $35,000 on how much money can move from the 529 to the Roth IRA. 

The purpose of this rule is to give an exit-option for any left-over money in the 529 account. Presumably, parents wouldn’t want to overfund their kids’ education if it means facing hefty tax penalties, and this gives them an out. At least for a limited amount. That limit is there to prevent people from taking advantage of the 529’s tax-treatment in order to fund Roth IRAs. If your goal is to fund their retirement via a 529 account, you have to thread an awfully narrow needle. This can be especially difficult if your kids are young, or if you’re unsure about whether college will still be a good investment. 

For funding other goals in adulthood, a good option to consider is an UTMA/UGMA account. This is a taxable custodial account that your kids get access to at adulthood. The problem to watch out for here is the "kiddie tax" which says they need to file taxes if they receive income of more than $1350 in a given year in the account. And if they earn more than $2700 in investment income, that income gets included on their parents’ tax return. Quick FYI: your child can still be considered a “kiddie” until age 24 if they are a full-time student. That means their dividends, interest, and capital gains will appear on your taxes. This is a problem because when your kid is 18-24, odds are good that you will be in your peak earning years, ie, the highest tax brackets you will see in your life. 

Accordingly, these accounts aren’t ideal for funding college. The 529 is better. But if you’re trying to emphasize flexibility, and give your child the option to go to grad school, or buy a house, or start a business, these are actually pretty good. And the taxes can be relatively manageable, at least up to a point. 

If you park these in an ETF there can be minimal taxable income, just dividends. Over the last decade, the S&P 500 has had a dividend yield around 2%, so that means your child can have up to $67,500 growing tax free. In other words, it would take $67,500 to generate more than $1350 in dividends.. And dividends exceeding that amount will probably result in a relatively manageable tax bill. 

The other risk I see for this route is that your kids get full control of these funds at age 21, depending on your state. Kiddie tax doesn’t necessarily go away either at this point. So legally speaking nothing stops your kids from cashing out their investments, buying a Mustang Convertible, and sticking you with the bill for the capital gains. 

The other downside is that UTMA/UGMA accounts count more heavily against need-based financial aid for FAFSA, compared with 529 accounts. 

If you prefer to optimize for simplicity and control of your assets, you might want to skip the UTMA/UGMA rigamarole and simply invest the funds yourself, in your own, taxable brokerage account. You’d pay taxes on the dividends and interest, but most passive vehicles should make these taxes relatively manageable. Then, once your kids are 18, you can decide how those funds will be spent. You have some added flexibility here too. If you’re in a high-earning (and high tax) phase and you have the extra cash flow, you can make gifts to your kids or their tuition bills directly from your regular cash flow, without selling investments. This helps you avoid capital gains taxes that would have resulted from selling the assets. Then, you can either give your kids the shares later, or keep them for yourself, having already met the commitment you set out to meet. 

All of these accounts are limited in how much you can transfer to your kids either explicitly or in terms of practicality. Your choice of account depends on how you would like to benefit your child.  Personally, I’d favor a mixed approach, especially if your kid is very young. Making at least some 529 contributions makes a lot of sense to me. Most people benefit from a college education or trade school, and most people won’t get a full ride scholarship to pay for it. You don’t need to cover a $250,000 Ivy League education to help your kid. In fact, I think a lot of kids would rather go to state school and get $50,000 toward a house. Likewise, you might not be able to pre-fund all of their retirement, but maybe you can make a big dent in it for them. 

While these various approaches make it possible to transfer large sums of money to your kids, it also begs a question, “how much should you give your kids?” Which is probably a topic for another article.