How to give the gift of Christmas future

Kimberly Allen has decided not to give the children Christmas presents this year.

She’ll give them each a Christmas future instead.

“I have decided to open savings accounts for my grandbabies and teenage daughter,” says Allen, of Newark, Del., who plans to deposit a few dollars in the accounts each pay period. “I just want them to understand that any cent they put away will benefit them.”

To be sure, Christmas futures aren’t nearly as fun to rip open as Christmas presents. But with college tuition costs rising at more than 5 percent annually, an investment in a child’s financial future may bring more happy returns in the long run.

The good news is that investment options for children come in as many shapes and sizes as holiday sweaters.

Here are some of the advantages and disadvantages of popular investment choices:

Savings bonds

U.S. Treasury savings bonds used to be a staple investment to enclose in holiday cards. Today they are less popular, as investment opportunities have expanded.

The good thing about giving bonds is that they are a simple, low-risk investment. The drawback is that they don’t yield high returns compared with many other investments.

529 plans

Named after a section of the Internal Revenue Code, 529 plans were designed to help save for a child’s higher education by creating an account that could grow tax-free, as long as it was used for education purposes. The plans, which vary by state, include a number of investment options, such as stocks, bonds and money market accounts. Pre-paid plans, offered by both states and educational institutions, allow savers to pre-pay tuition, locking in today’s rates for tomorrow’s study.

One of the benefits: a high cap on maximum contributions: up to $12,000 per year.

A drawback is the money can be used only for higher education. And if the money is not used for higher education expenses, there is a 10 percent penalty on withdrawals.

Coverdell accounts

Like 529 plans, Coverdell Education Savings accounts allow savings for education to grow tax-deferred, as long as withdrawals are used for education expenses. Unlike 529 plans, Coverdell accounts can be used for any type of education, from kindergarten to post-graduate. However, the Coverdell has a maximum contribution limit of $2,000 per year.

Custodial accounts/stocks and mutual funds

Giving shares of stocks or mutual funds to a child can help educate them about investing.

Custodial accounts, known in technical terms as UGMAs or UTMAs (named after the Uniform Gifts to Minors Act and the Uniform Transfer to Minors Act, respectively), allow a child to own stocks, bonds, mutual funds, and other assets through a custodian until the child comes of age (18 or 21, depending on the account) and assumes ownership of the assets.

Jon Walton, a certified financial planner at Independence Wealth Advisors in Wilmington, prefers mutual funds to stocks for children because they are more diversified and hence less prone to dizzying ups and downs.

“If you gave them 20 shares of Enron, they might never invest again,” he said.

There are some drawbacks to opening a custodial account for a child, says Brad Foy, a certified financial planner at Bassett, Brosius & Dawson, a Wilmington investment firm.

First, because the child takes ownership of the account at age 18 or 21, the child has the freedom to spend it on something other than education. Also, a child’s assets count against him for purposes of financial aid. Finally, the investments inside the account do not grow tax-deferred.

Roth IRA

If a child is old enough to have a job, friends and family could consider pitching into a Roth Individual Retirement Account.

The Roth IRA doesn’t provide tax deductions on contributions, but it allows money to grow tax-free until retirement. Any child with earned income can start an IRA, and can contribute up to $4,000 per year (or 100 percent of their income if they earn less than that), says Carol E. Arnott, a certified financial planner with the Greenville Financial Group.

The benefits are that a child can use Roth IRA money for education without paying a 10 percent penalty; only the earnings will be taxed upon withdrawal. If not used for education, the money can be used later for retirement.

The downside? That control issue again.

“When you put it into a Roth IRA, it is the child’s money,” says Arnott. “So if they’re going to be irresponsible about it, maybe a 529 is the best way to go.”