Parents can guarantee incredible financial gains for their children by beginning the investment process now. While understanding what the best investments for kids are, it’s a broader topic in the sense that there are many important facets to the discussion. Things like when you should begin investing for your kids, what types of accounts are appropriate for kids and what are the tax ramifications of various investment strategies. When it comes to investing on behalf of your children and making strides towards their very bright financial future, all of these things can be important elements.
When we consider investing for our kids, most of the discussion revolves around college savings, and this is absolutely a relevant component. But, there are a myriad of additional things we can do to invest for our kids. We’ll look at each of these in this article.
What types of accounts are best for investing for our kids?
529 College Savings Account
A 529 account is one of the most common and best investments for kids. While these accounts are aimed primarily at saving for a child’s college expenses, the flexibility and tax treatment of these accounts make them quite attractive. First, you can contribute quite a bit to a 529 account (essentially up to $30,000 per year according to current gift tax exemptions – this is explained here). You can also execute a superfunding of a 529 account if you want to acelerate the contributes of several years into a one-time contribution.
With the recent tax code changes, parents can use 529 accounts to fund private school during the K-12 phase as well. Additionally, if your kid doesn’t end up using the entire balance of the account for college, you can change the beneficiary on the account to another child (or yourself).
Gains are tax free when utilized for education expenses. Depending on your state, you can potentially deduct 529 contributions from your state taxes as well.
All in all, 529 accounts are incredibly useful and flexible. They are probably the first investment account you should open for your child after they are born. The 529 savings account is a core component of your investment plan for your children.
While there are restrictions around participating in a traditional IRA or Roth IRA, if you’re able to pull it off for your child, what an incredible benefit you can bestow upon your child. Let’s first look at the restrictions and how to open an IRA in your child’s name, then we’ll tackle why this is such an amazing benefit for a child.
IRAs, or Individual Retirement Accounts, are investment accounts geared towards saving for retirement. They have various tax benefits depending on the type of IRA, and they have various restrictions around participation and how the money is withdrawn. There are no age restrictions on opening an IRA, so age will not prevent your child from opening an IRA.
The primary participation restriction revolves around earned income. If a child has earned income, he or she can contribute to an iRA (either traditional or Roth). Note that the IRS defines earned income as taxable incomes or wages. So, if your child has a W-2, he can absolutely contribute to an IRA. If your child earns cash from neighbors for babysitting or mowing lawns, it’s possible to also contribute to an IRA, but the child would have to report this as actual income. Talk to an accountant more about this if you decide to go this route.
The best case scenario here is a child opens and contributes to a Roth IRA. The contribution limit for 2019 is $6,000 per year.
Why would a Roth IRA be so impactful for a child’s future? The key to this is compounding. Starting in your teenage years regular contributions can result in massive wealth being generated for later years. Let’s look at an illustrative example to show how impactful this can be.
In the below chart, the first person begins investing $6,000 per year at age 15 and continues until age 65. The second person begins investing $6,000 per year at age 25 and continues until age 65. Both have an average of 8% annual returns.
As you can see the ending balance for person 1 is much larger (over twice as big) as person 2. Yes, person 1 contributed $60,000 more dollars overall, but the major difference is the extra time for compounding to really kick in. By starting at age 15, the first person will end up with over $4 million in his or investment account off of just $300,000 of contributions. Talk about having the opportunity to get super wealthy even if you never earn big bucks! Oh and if this is a Roth IRA, that $4 million is tax free! Incredible.
IRA accounts can be opened as custodial accounts where the parent is often the custodian. The custodian manages the account until the minor reaches age 18 or 21 (depending on the state). The funds in the account belong to the child whether or not the child is still considered a minor.
A few more notes on why Roth IRAs are one of the best investments for kids. Roth IRAs are more flexible than traditional IRAs. While typically withdrawing money from retirement accounts early comes with penalties, Roth IRAs let you withdraw the contributions early if you need the money (not the earnings/gains).
While it’s not ideal, you can also withdraw the earnings of a Roth IRA for education expenses (you’ll pay taxes on the gains,but there’s no penalty for early withdrawal). Lastly, if the Roth IRA has been contributed to for five years, the child can take up to $10,000 in earnings out to pay for a first home (tax and penalty free).
Before we move on, let’s circle back to the eligibility and funding discussion. If your child is working and earning money, it’s pretty normal for the child to want to use that money for things like his car or other spending. But as long as he or she is earning income, YOU as the parent can contribute to the Roth IRA in your child’s name. If you have the means, the long-term benefit here really can’t be overstated.
Overall, a Roth IRA is so incredibly powerful. If your kids college accounts are already funded, and the child is working a job, get that Roth IRA going. What a legacy to provide for your child.
Another possible route for investing for your kids is a CD ladder. If you don’t want to mess with the market or IRS regulations, a simple CD ladder can be a great way to save money in your child’s name.
When implementing a CD ladder, you simply purchase multiple certificates of deposit with varying durations (and usually interest rates). This will result in having several CDs that mature at regular intervals. As long as you don’t need the money, you can continue to roll these CDs over into new terms. You can repeat this process as long as you wish to keep the money in savings and keep the money generating interest.
Often times, individuals will use CD ladders for emergency funds or money they are saving for a down payment on a home.
UTMA refers to Uniform Transfer to Minors Act, and UGMA refers to Uniform Gifts to Minors Act. You might think of these accounts as essentially custodial accounts that are non-retirement accounts. What’s the difference between an UTMA account and an UGMA account? UGMA accounts are typically used for cash, stocks, mutual funds, bonds and insurance policies where an UTMA account can also include any type of asset such as real estate and other items.
You can contribute to a minor’s UTMA or UGMA account based around federal gift tax exemption rules. This means that in 2019, each parent can contribute $15,000 into a child’s account without incurring federal gift taxes. It’s worth noting that these contributions are irrevocable meaning you can’t transfer them back.
Earnings on these accounts are subject to federal income or capital gains like any brokerage accounts. Also, there’s something called a “kiddie” tax which states that if the interest, dividends or investment income total more than roughly $2,000, part of that income might be taxed at the parent’s tax rate. Discuss tax ramifications of an UTMA or UGMA account with your tax professional.
When is an UTMA account appropriate? If you’re looking to build up a non-retirement and non-college savings account in your child’s name, this can be a good method.
Your Own Savings Account
Some parents want to build the best investments for kids, but don’t necessarily want to fool with custodial accounts or opening additional accounts in the children’s names. You can still set money aside “earmarked” for your kids in separate savings or brokerage accounts that remain in your name. Then, when you deem the time is right, you can give this money to your children. Make sure you’re examining all tax ramifications associated with gifting money to children, however.
How to open a brokerage account for your child
Most of the large brokerage companies such as Schwab and Fidelity offer all of the child investment accounts you’d consider. This includes 529 college savings accounts, a custodial IRA and a custodial brokerage account (UTMA). In order to open a brokerage account for your child, first you must determine the type of account you want to open. If your child has no taxable income or wages, then you’re looking at either a custodial brokerage account or a 529 savings account.
Next, you need to choose the broker. Schwab, Vanguard and Fidelity have been pretty much leading the way with low cost investment account options. Check out each of those and talk to a representative if you want to do some more research. For the most part, there isn’t much difference between the standard brokerage offerings anymore, however, places like Schwab offer an Intelligent Portfolio (often referred to as a roboadvisor) that will manage the asset allocation based around a few parameters you provide. The Intelligent Portfolio offering is applicable to custodial brokerage account.
Next, fill out the appropriate paperwork and open the account. At most of the larger brokers, this can be done entirely online now. Ensure you have your child’s social security number handy as it will be required for most options.
Lastly, determine what you want to invest in! This brings us to our next important sub-topic of choosing the best investments for kids… the actual stocks, bonds and funds to put in your children’s investment accounts. Let’s dig into it…
Best investments for kids
So you’ve got your college saving account or brokerage account setup in your kids name. Now what? What are the actual best investments for kids that you should be selecting for the account? And by the word investments, we mean specifically, stocks, bonds, etc.
If you’re completely new to the investing game, you want to keep it pretty simple. I’d strongly discourage jumping into a game of picking stocks. Before making major moves, read some of the books listed at the bottom of this article on the basics of investing. Then, if you’re able to choose any ETF or instrument for the account (some college savings accounts, for instance, have limited options), then consider starting with a simple three-fund portfolio (as outlined in the below book).
The three-fund portfolio essentially aims to provide broad, diversified exposure to US stocks, US bonds and international stocks. You can get super low-cost ETFs and accomplish a very diversified portfolio that performs very well historically by just buying three simple ETF funds. Here are examples at the three large brokerages:
- Schwab: Total Stock Market (SCHB), International (SCHF), Bond Index (SCHZ)
- Fidelity: Total Stock Market (FZROX), International (FZILX), Bond Index (FXNAX)
- Vanguard: Total Stock Market (VTI), International (VXUS), Bond Index (BND)
Again, the three-fund portfolio is a really nice place to start. Some investors like to add a small percentage to some alternative investors such as real estate investment trusts (REITs), but unless you’re pretty familiar with investing already, I’d stick to the simple allocation as outlined above.
Now, many accounts such as 529 accounts don’t let you choose the individual ETFs to go into the account. For example, the 529 accounts I have for my kids request that I simply allocate a percentage of the account to an aggressive, semi-aggressive or conservative allocation. If your kids are young, aggressive makes sense. If they are approaching college age (and this is a 529 account), you’ll want to move that to a much more conservative allocation to limit the risk of capital loss right before you need it.
Additionally, many brokerages offer target date funds now. For instance, if you know you’ll need the funds in a 529 account in 15 years for college (and assuming it is the current year of 2019), you can put the money in a 2035 target date fund. This fund will automatically adjust the allocation inside the fund towards a more conservative allocation as the target date approaches. It’s essentially managing this element of the portfolio for you.
Lastly, consider the intelligent portfolio / roboadviser approach if you’re looking at a custodial brokerage account. These accounts will manage the rebalancing and asset allocation for you based on your answers to a few questions about the account, your goals and your tolerance for risk.
By and large, when it comes to our kids, the timeline is quite long. Therefore, you can be heavily allocated to stocks (equities). Perhaps even 100%. If you know you’ll be investing continually on an ongoing basis, then going 100% stocks makes perfect sense on a super long time horizon. If you’re planning to plop a major chunk of money into an account at one time, then maybe you consider easing it into the stock market over a period of time to avoid a complete entry at the top of a market.
Be sure to educate your children!
If you’re contributing into your child’s financial accounts, it’s a good idea to ensure there’s a proper level of education occurring at the same time. While you should be teaching proper spending and saving habits to ensure that your kids don’t spend all this money that you’re saving for them, you also want to ensure some quality investing education as well. There are some excellent beginner investing books you should consider reading with your child (once they are old enough). Here are three examples:
Little Book of Common Sense Investing
This book is simple and won’t be too intimidating for young investors. If you haven’t read it yourself, give it a read. Then, read it again with your kid. You can click here to buy it.
The Bogleheads’ Guide to the Three-Fund Portfolio
This book is crucial for learning about simple asset allocation. There’s quite a bit of noise on the subject of asset allocation, and this book will instruct you and your child on how to execute a very simple and effective allocation that can work through a lifetime of investing. You can click here to buy it.
The New Coffee House Investor: How to Build Wealth, Ignore Wall Street, and Get On With Your Life
Another simple (and short) book to introduce investing. A great gift for recent graduates. You can click here to buy it.
To help illustrate the topics discussed here, let’s look at a specific example of choosing the best investments for kids. Of course, the higher your income, the more you’ll be able to do, so let’s look at a simple approach for someone doing well, but nothing crazy.
Bob and Sue have two kids and have a household income of $125,000. They live modestly, below their means in order to be able to invest wisely in their own retirement and towards their kids future. Bob has a really good 401(k) plan with generous matching which enables him to be flexible in additional savings and not feel the urgency to put every dime into his own retirement. Note: Your own retirement is more important than your kids finances. Make sure you are investing HEAVILY into your own retirement!
When each of their children were born, Bob and Sue immediately opened 529 college savings accounts in their kids’ names. They also immediately began contributing $100 per month into these accounts. After a few years of settling into the rhythm of life (and expenses) with kids, they upped this amount to $200 per month for each kid. The market has been good so these accounts have grown nicely as the kids have hit the teenage years. Since their kids plan to goto in-state public Universities, they are well on track to completely fund the education expenses. To be doubly-sure, Bob and Sue plan to increase contribution for their oldest kid to $300 per month (or more) in the last few years before they head off to college. If they overfund the 529 account, they can change the beneficiary to the younger child after the fact.
Since the oldest child is also now working, Bob and Sue have opened a Roth IRA in the child’s name. The child pays for his own automobile expenses, so Bob and Sue are contributing to the IRA themselves with their own money (at a rate of $100 per month). It’s not a ton of money, but they’re excited to help seed their children’s retirement funds. The Roth IRA accounts have a simple three-fund portfolio as the allocation strategy. Bob uses the same strategy for himself, so he figures it will work well as the best investments for kids.
As their kids goto college and beyond and Bob and Sue’s direct expenses involved with raising children go away, they may continue contributing to their children’s Roth IRAs while their kids work on their careers. This will depend on Bob and Sue’s status toward their own retirement goals. And, of course, they’ll stop contributing to their kids’ accounts when the kids start to work their way up a bit in their careers and begin earning more money. It’s not necessary, but they remember how it can be difficult in those early years to have extra money to save for retirement, save for a house, save for a family and more.