Like many parents, I have been tucking money aside for my boys’ futures since they were born. Initially, that meant putting cash into a high-yield savings account each month. As time went on, though, I wondered whether I could make that money work even harder through the power of investing.
After some research, I decided that the best way to grow their savings was to take a multi-tiered approach. So although I still contribute to that old-fashioned savings account each month, my kids (and my nieces) now also have their own investment portfolios. And yes, that even includes my 7-year-old.
Today, let’s take a look at the value of starting an investment portfolio for your kids, how this differs from traditional savings, and where your efforts will be the most impactful.
Investing for kids: why it makes sense
Most of us already recognize the value of investing as part of our financial strategy, especially when compared with putting money in a basic savings account or stashing it under the mattress.
What you might not realize, though, is that investing for your children can provide them with many of the same benefits you already enjoy — and then some. Plus you can get started today, no matter how old your kids are.
Time is on your side
Time is the most valuable factor when it comes to saving for the future. The earlier you begin saving and investing, the bigger the impact your efforts can have. This happens for a few reasons:
- All other factors aside, the simple fact is that the longer you save, the more money you’re able to contribute to savings. Putting $200 a month into an account for five years is great, but putting $200 a month into an account for 15 years is even better… and that’s before you even get into interest and earnings.
- Compound interest allows your money to grow, by earning interest on your interest. The longer compound interest has to work on your interest-bearing accounts, the more growth it can generate.
- The longer you hold an investment portfolio, the better you can wait out a slow market. Peaks and slumps are an integral part of investing, though they can sometimes last a decade or more. By building your kids’ investments as early as possible, you are more likely to balance out the impacts that a down market can have on their portfolio’s growth.
When it comes to your own investment portfolio, you probably already know that saving what you can today is better than waiting to start until you’re older — or have a better job, or earn more money. Time is one of the biggest indicators for growth when it comes to saving and investing, so it’s easy to see how much your kids could benefit.
Earnings can be much higher
If you put your savings in a high-yield savings account, you may earn a percent or two in interest each year, but it’s usually just enough to break even with inflation. And as of Oct. 5, 2020, even the best savings accounts are offering less than 1% APY.
If you invest your savings instead, though — whether in mutual funds, exchange-traded funds, or even individual stocks — you have the chance to grow those funds exponentially. Take the S&P 500, for example. This benchmark index has earned an average annualized return of 11.12% over the past decade. That is more than 10 times what your best savings account would earn today.
Although investment returns are never guaranteed, there’s an opportunity that an investment portfolio may grow their savings significantly more than a piggy bank or savings account ever could.
Tax rates are kind to kids
Depending on how much you contribute to your child’s investment portfolio, and how much that account earns throughout the year, you may find that the IRS is quite kind when it comes to taxes.
Custodial accounts are subject to taxes (often referred to as the “kiddie tax), but only if your child’s earnings are greater than $2,200 in a given year. That threshold includes interest, dividends, and other unearned income.
This means that if your child’s investment portfolio generates less than $2,200 a year in dividends, they will be able to enjoy tax-free growth all the way up to their 18th birthday.
It’s a great financial lesson
As parents, it’s our job to teach our kids about saving money, living within their means, and planning for the future. Letting your kids watch their investments grow over the years can be a great way to pique their interest.
You can use their portfolio to teach important lessons about budgeting, automating savings, the power of interest, and the stock market, depending on your kids’ ages. Plus, your child may find it fun to choose a theme-based mutual fund that interests them or buy shares of a company they support.
Before you start investing for your child
You know you want to start investing on your child’s behalf. Now what? Well, now you need to determine exactly how to invest money for them.
Before you get started, take the following steps. These will allow you to not only develop a strategy, but also choose the right investment and savings vehicles for your kid(s).
1. Set specific goals
In order to determine the best way and place to save, you need to decide why you’re saving in the first place. This involves setting specific financial goals for the future.
Think about why you want to start investing for your child. Are you planning for their college expenses? Saving for their first house? Giving them a serious head start on retirement? Or it could be something else entirely.
Once you know why you’re saving, it’ll make it easier for you to decide things like how much to save and which savings vehicle to choose.
2. Make a plan for contributions
Next, you should plot out how much you need to contribute in order to meet your goals, as well as what you can realistically afford.
Of course, your contributions can change over time according to your financial situation, but this should at least give you a rough idea of what you should (and can) do today.
3. Weigh your options
Lastly, you should compare the different savings vehicles available to you, when it comes to planning for your children’s future. You may want to ask questions such as:
- What sort of accounts are available to me?
- Which ones will help optimize my specific savings goals?
- Are there tax advantages involved with any of these accounts?
In some cases, the answer will be clear. For others, you might want to explore opening and funding more than one account, especially if you have multiple savings goals for your kid(s).
To help you decide which accounts are best for your child’s investment and savings plans, here is a look at the accounts you’ll most likely consider.
Investing for kids: types of accounts
There are five primary investment account types for kids, depending on whether you’re saving for short- or long-term goals, how much you have to set aside for your child, and how you want the money to be used.
Custodial brokerage account
A custodial brokerage account is the closest to a traditional investment account you can open and manage on your child’s behalf. Also referred to as a UGMA (Uniform Gifts to Minors Act )/UTMA (Uniform Transfers to Minors Act) account, these include mutual funds, ETFs, individual stocks, and the like. Some of the best brokerage accounts even allow for themed investing, so you can buy into companies that support specific social or environmental causes that are important to you.
There are typically no contribution limits with a custodial brokerage account. Your child’s portfolio can be funded with after-tax dollars from parents, grandparents, friends, or anyone else.
With a custodial account, your child is officially designated as the owner. When they come of age (anywhere from age 18 to 25, depending on the state), the account is transferred into their control and they can use the money for whatever they want … no limitations.
Until then, you are able to manage the portfolio as you see fit. Funds can be withdrawn but must be used solely for the benefit of the minor owner.
If you are saving and investing for your child’s future educational expenses, a 529 account may be an even better option. Although the rules on 529s can vary from one state to the next, they all provide a vehicle for tax-advantaged savings that can be used on K-12 or post-secondary education expenses.
There are contribution limits on 529 plans, which range from $235,000 to $529,000, depending on the state. Contributors may be able to add funds to a child’s 529 account without it affecting their lifetime gift exclusion, however, and the 529 plan will grow tax-free over the years (capital gains taxes may be imposed upon withdrawal, however).
Penalties are usually incurred if funds are used for non-educational expenses. Ownership of a 529 plan also remains with the account’s founder, rather than the beneficiary.
Custodial individual retirement account (IRA)
As long as your child has earned income over the course of the year — either by helping out at the family shop, starting their own lawn-mowing business, or working for the pizza place down the road — they are eligible to contribute to a Roth IRA. A custodial IRA is one that is held and managed by an adult on the child’s behalf, but ownership is then transferred once the child reaches age 18 (or 21 in some states).
Your child can contribute up to $6,000 a year to their custodial Roth IRA, and the balance will enjoy tax-free growth over the years. Although there are no tax deductions involved with a Roth, there are no taxes imposed on withdrawals down the line, either.
A custodial Roth IRA is an excellent idea if you want to give your child a head start on their long-term retirement savings, especially because it offers tax-free growth.
If you’re looking to build your child’s savings over a shorter period of time, consider the value of a certificate of deposit account, or CD account. These time-restricted savings accounts offer higher, guaranteed interest rates in exchange for locking away your funds for a specified period of time. Just be sure you won’t need to use that money before the CD period ends, or you’ll likely be subject to early withdrawal penalties.
With CDs, you have guaranteed compound interest growth, especially if you redeposit the funds into a new CD after the term ends. You can also ladder your CDs to balance growth with liquidity.
Money market account
Similar to a high-yield savings account, money market account, or MMAs, are savings vehicles that offer higher-than-average returns on your child’s savings. They can be held on your child’s behalf, with no contribution or use limits, though interest rates are subject to fluctuation.
Although you can use MMA funds for any purpose at any time, you are limited to a maximum of six account withdrawals in a statement cycle (as per Regulation D from the U.S. Securities and Exchange Commission. If you exceed that federal limit, you may be penalized or your account could be closed.
Investing for kids: how to start
Once you know which kind of account you want to start for your child and how you’ll manage the funds, it’s time to sign up.
1. Choose a platform
Depending on the type of account you’ve chosen, there are a few great platforms to consider.
- For custodial brokerage accounts: Acorns is one of the most family-friendly options around, offering their new Acorns Early platform. With Acorns Early, you can set up automatic contributions to custodial accounts for any number of children, along with learning through its financial literacy content. Alternatively, you could choose a platform like UNest.
- For 529 plans: While many states have their own 529 accounts and designated platforms, you aren’t required to use your state’s 529 plan — you can use any 529 plan. Make sure to compare plans to find the best option.
- For Roth IRA: Fidelity makes opening and managing a custodial Roth IRA easy. Their website provides a resource-rich library for parents and children, and each Roth IRA for Kids account has access to a variety of different investment options.
- For CDs and MMAs: When it comes to these types of accounts, you’ll want to choose the best interest rate you can find. Many online banks offer a range of products with competitive returns.
2. Sign up
These days, you can set up an account for your child online in almost all cases, which makes it quick and easy to begin investing (or saving) for the years to come.
If you’re signing up for a custodial account, you’ll need to have your information as well as the child’s information handy. This includes their Social Security number, birthdate, and address. You may also need to provide information about your funding sources — like your bank routing and account numbers — especially if you are setting up automatic contributions.
3. Start contributing
You have the account, now it’s time to start contributing funds.
Setting up auto-transfers is an easy way to build up funds without needing to think about it weekly or monthly. You can always increase or decrease contributions later as your budget allows.
You may want to give the account information to grandparents, aunts and uncles, or others who are interested in contributing to your child’s future, especially for things like birthdays and Christmas. Some accounts have contribution limits, so be sure to coordinate with other contributors so you don’t exceed those limits.
FAQs about investing for kids
How do you start investing for kids?
Investing for your children is simple and beneficial. Once you have a goal in mind, you can open the right account, whether it be a custodial brokerage account, 529 plan, custodial Roth IRA, or as simple as a CD. Many of these accounts allow for tax-free growth, though some may have rules for withdrawal and/or contribution limits.
Can you open an investment account for your child?
A custodial brokerage account allows you to open an investment account for your child and manage it until they come of age. The account can be invested and grow over time; once ownership is transferred, your then-adult child will be able to use the funds for a variety of uses, such as educational expenses, a first down payment, or toward their retirement savings.
Can I pull savings out from my child’s custodial account and replace it later?
You can withdraw funds for your child’s custodial brokerage account as long as they will be used for the child’s benefit. Once your child comes of age and takes over account ownership, they can withdraw funds and use them for any purpose.
The bottom line on creating an investment portfolio for your child
Most parents recognize the value of creating a savings account for their child, whether to build a college savings or give their kids a headstart in life. However, many don’t realize that it’s also possible to open an investment account on their child’s behalf.
While all investments come with the risk of loss, an investment portfolio for your child, also known as a custodial brokerage account, may help you save for your child’s future. There are certain tax advantages in place and your child will automatically assume ownership once they come of age, which allows them to spend the funds (plus growth) on whatever they need in the future.
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