Tax-Free Investments for Children

If you’re saving for your child, chances are you’re putting money away for their education expenses. Here’s the good news. When you invest in certain account types, your money can grow tax deferred. Better yet, when you use the distributions from these accounts for qualified education expenses (529 Plans, Coverdells) or the distributions are qualified (Roth IRAs), your distributions are tax free. 

Let’s review these tax-free and tax-deferred investment account types that can benefit your children: 

• 529 Plans – These are education savings plans offered by nearly every state. State tax deductibility and maximum contribution limits vary depending on the plan. You usually can only choose investments offered by the specific plan. You can use the money for educational expenses at any level, including primary or secondary school, college, and university. 
• Coverdell IRAs – These education savings accounts allow you to put in $2,000 each year into whichever investment vehicle you choose. Contributions to a Coverdell IRA are not tax deductible. You can use the money for educational expenses at any level, including primary or secondary school, college, and university.
• Roth IRA – Most people are familiar with Roth IRAs as a retirement investment. But qualified distributions from these accounts can also be used to pay for education expenses. The annual contribution limit is $5,500 ($6,500 for people age 50 or over). Like a Coverdell, the contributions are not tax deductible. 

Note: In order for the investment distributions to be tax free, your withdrawal must be a distribution of principal made five years after the Roth account was created (the five-year rule). If the account is at least five years old and the account owner is 59 ½ or older, the investment distributions are tax free, regardless if they are a withdrawal of principal or earnings. 

What counts as a qualified education expense? That is determined by the specific plan rules for college savings accounts (529 or Coverdell). Be sure to review the rules carefully before making a distribution. 

Tax-Exempt Interest Income

You might also be interested in investing in accounts that offer tax-exempt interest income that are not necessarily education savings accounts. Certain state and municipal bonds provide tax-exempt interest income. Exempt-interest dividends as a shareholder in a mutual fund or other regulated investment company are also nontaxable vehicles.