Trump accounts may not be the best for your kids
You have probably heard about Trump Accounts (TA), the new tax-advantaged investment account designed to promote “long-term financial security for millions of kids”. And while it’s true that small savings today can grow to staggering numbers in the future, it is not necessarily true that this particular investment account is the best option for that goal.
The main reason for this is the tax-deferral mechanism of the TA, but there are also reasons to be wary of the limited flexibility of the account, both in the investment options and the ability (or lack thereof) to withdraw funds before age 18. In fact, there may be alternatives that will better accomplish the goal of long-term financial security.
Trump Account key points:
For children born (or to-be-born) in years 2025-2028, the US Treasury will make a one-time $1,000 contribution on behalf of the child.
Contributions are made with after-tax dollars. In other words, you do not get a tax deduction for contributions.
Contributions are automatically invested in an index fund tracking the S&P 500. (Specifically, State Street SPDR Portfolio $SPYM)
All income is tax-deferred, meaning you won’t be taxed until the money is withdrawn from the account.
Funds in the account are inaccessible until the child turns age 18, at which point the account turns into something resembling an IRA, with penalties assessed on withdrawals prior to retirement age.
In short, the account functions like a nondeductible IRA that you can fund without the need for earned income. And if you’ve never heard of a nondeductible IRA, it’s because the account type has neither the tax deduction for contributions nor the tax-free growth and withdrawals that make Traditional IRAs and Roth IRAs (respectively) such useful accounts. In other words, the nondeductible IRA kind of stinks.
Alternatives to Trump Accounts
For everyone else, I would think twice before contributing to the account. Here are some alternatives to consider, depending on your goal.
529 College Savings Plan – Contributions to this account are deductible from your Nebraska income tax return, income is tax-deferred, and withdrawals for qualified college expenses are tax-free.
Good for: College savings
Custodial brokerage account (UTMA) – Like the Trump Account, contributions are made with after-tax dollars. Income is not tax-deferred, but that may be a good thing. The IRS has kiddie tax rules that exempts from tax a certain portion of investment income generated by a child’s account, and unless you have gobs of money in this account, you likely won’t pay any tax on the dividends.
Despite the favorable kiddie tax rules, these accounts are not considered “qualified”, so there are no restrictions on how and when you can use the funds. Need some money to buy his first car at age 16? The UTMA is there for you!
Good for: Flexibility – funds can be used whenever and however you want.
Kiddie tax explained:
Income produced by an asset owned in the name of a child (such as a custodial brokerage account) will be taxed to that child.
The first $2,700* of income (dividends or capital gains, but this also includes wages if the child has a job) will be taxed at 0%.
Once the income has been “taxed” (even at 0%) you can reinvest it and it becomes “cost basis”, meaning it will not be taxed again.
Contrast this treatment of income to the Trump Account, in which the taxation of those annual dividends and capital gains are deferred to the time of withdrawal, when it could be taxed at 10%, 12%, or even 22%. Tax deferral sounds great, but I would rather “pay taxes” today at the rate of 0%.
*Last year, SPYM (the ETF which your Trump Account funds are invested in) had a dividend yield of ~1%, meaning you would need $270,000 in the account before you eclipsed the kiddie tax limit.
Who should consider using this account?
You should strongly consider opening an account for a child born between 2025-2028, as the $1,000 is more or less “free money”.
For certain children under age 10, there has been a philanthropic donation announced, but nothing is set in stone. More info here: Landmark Dell Gift Supercharges Trump Accounts for America’s Kids – The White House
Summary
Ultimately, the marketing of the Trump account has done a lot to remind the nation that starting early with savings can be a great idea. However, there are options with even better tax benefits that may be better suited to saving for children.
This article is for educational purposes toward a general audience. Personal finance is personal – see an expert regarding your own specific situation.
About the Author
Joseph Fowler, CFP® is a financial planner and co-owner of 402 Financial in Lincoln, NE.
402 Financial helps people who are in or nearing retirement spend their money. Joe always acts as a fiduciary and never takes commissions on product sales.
If you are considering retirement, click this link to see if you have enough.
