Financial Planning For Your Young Children 101- 8 Investment Accounts For Kids
Introduction to 8 investment accounts for your children
You are a proud parent of a new child, congratulations Anon.
Children are absolutely the greatest gift in life and a huge new responsibility for you…However, like my dyslexic Uncle Neb always said, “with great responsibility, comes great power”.
In this case, you have the power to set your new bundle of joy up with a solid financial foundation. You can ensure they get through childhood on “3rd base” with all the financial opportunity they could ask for.
“With GREAT responsibility, comes GREAT power”
-Dyslexic Uncle Neb
This post will give you a rundown of 8 different child accounts available. The paid post later this week will dive into strategies and how we would (and do) use these accounts.
But first…
Self-Care Comes First
Get your finances in order first.
The absolute best way to help set your kids up for financial success is to be successful with your own finances.
Don’t put off your own retirement savingsto start saving for your child’s. Especially if investing for your kid is going to cause you to come up short. If you require the financial help of your children in the future, you undo all the work to set them up financially. Just making your own situation solid, puts you on the path to helping the kids out.
Here is the order of your focus:
Get 6-figure+ income
Refinance any high interest debt & use the ‘Infinite 0% APR debt cheat code’ to lower the cost
Set aside 3-12 month emergency fund
Pay down any remaining high-interest debt
Invest 25%+ of your earnings
Pay any lower interest debt (if you want)
Consider to start saving money for your kids
Yes, there is a lot to do before you divert your own money into retirement/college savings for your kids. Trust. You do it so your kids don’t need to take care of you in old age…Also, you should be doing 1-6 anyway. It doesn’t matter how (budget/401k/IRA/2 jobs/etc) just get step1-6 done.
Compounding Yada Yada Good Blah Blah
You have seen what 30 yrs of compounding does from every midwit gooroo.
“If you invest [some small amount] every week over [some large time period] you wind up with $1 million+!!!! (if you assume some very high compound growth based on ‘average historical returns’)”
-69.420% of tweets from personal finance gooroos
[You can read about how misleading average return stats are here, or why you can’t use average returns for a dollar-cost averaging strategy here. Now you are way ahead of the game.]
If you are able to start investing for a young child you are able to allow 50+ yrs of compounding for them.
To use the common misapplied maths…If you were to put $1,000 into an account for your child at birth and then each birthday through their 18th birthday, you would have put $19k into the child’s account. If they don’t touch the money until retirement (65 years old) and the money earns an annualized 8% return, they would have over $1.5 million.
If your child wanted to have $1.5 million at retirement by funding their account on their own starting at age 20, they would need to contribute over $3,500 a year for 45 years.
Your child would put in over $169k (nice) over the 45 years vs the $19k you contributed over 18 years.
[Insert ‘power of compounding’ and ‘compounding is the 8th wonder of the world’ comments here].
All else equal, your family just ‘saved’ $150k of expenses…This is the kind of stuff to grow generational wealth by having assets for children that grow over the entire lifetime. The ultra wealthy use the “Buy, Borrow, Die” strategy of maximizing compounding for their kids (which you can start to replicate using permanent life insurance).
Convinced? Good.
We will cover 8 different types of investment accounts:
Custodial Traditional IRA
Custodial Roth IRA
Custodial UTMA
Youth Brokerage
Custodail 529
Regular 529 (savings account & Pre-Paid)
Education Savings Accounts (ESA) / Coverdells
Child high-yield savings account
Custodial Investment Accounts
Custodial accounts means the account is opened in the child’s name and then a custodian is named who manages the account until the child comes of age. There are 3 main kinds of custodial accounts:
Custodial IRAs (child needs an income)
Custodial UTMA (child doesn’t need an income)
Custodial 529
Once money is put in the custodial account, it is considered to be the child’s, even if they can’t yet access or control it. That means if you withdraw money, it must be used for the benefit of the child. IE - you cant withdraw money for your own use and benefit.
Typically the custodian is a parent or grandparent.
Custodial IRA (Trad & ROTH)
Custodial IRAs are just like the IRAs you have. (you do have IRAs right Anon? They are tax-advantaged investment accounts and you should be taking advantage of that…errr…tax-advantage). The parent is listed as the account custodian and the child is the beneficiary.
Like regular IRAs, there is a traditional IRA that you provide pre-tax money to and it grows tax-free. The taxes are only recognized when you withdraw the money. There is also the ROTH IRA where you put after-tax money into the account and the money grows tax-free and you are able to withdraw it tax-free.
Only barrier to using custodial IRAs is the kid needs to be earning income. This typically makes IRAs for older children.
However, there are investment accounts that you can open for your child right away…
UTMA/UGMA Custodial Accounts
Uniform Transfers to Minors Act (UTMA) and its predecessor the Uniform Gift to Minors Act (UGMA) are non-college, custodial accounts for minors.
These accounts allow for adults to contribute money to an investment account for their child.
However, once the child comes of age, the account is theirs. That means they can do what they want as it is their money outright. So if your kid grows up to be a degenerate, they can take all the money and blow it at 18-21.
Additionally, these accounts do vary by state. And unlike some of the college accounts, you can’t transfer the money between children.
These accounts don’t have any tax advantage other than just the low earnings of the child conferring general lower taxes to them.
Youth Brokerage Accounts
Online brokerages have youth account options. Most of these start in the 13-16 age range and have different rules based on the brokerage.
Unlike UTMA or custodial accounts, these are the child’s. It is in their name and the child gets to make all the decisions on what to invest in.
Most of these accounts have some fail-safes for parents like:
Monitoring abilities
Approve new contributions or withdrawals
Notifications of trades
Point of contact for any suspected fraud
Again, each brokerage have their own rules but this may be an option that allows you to introduce investing to your teenager & get them involved in the process.
College Savings Accounts
The value of college is becoming…debateable…
There is an entire $Trillion+ industry that has sprung up around funneling kids to & through college, regardless of the value for the children. We have dubbed it the ‘college industrial complex’ and it is appalling how many people are in on the grift.
(The college industrial complex is named after another negative societal value-add industry, the military industrial complex).
If you are going to have your kids attend college, you should sit down and show them how to calculate the opportunity cost of going to college vs other options. And you definitely should direct them towards careers that make going to college worth it.
If you plan to direct your children down the traditional route of a college education, there are some tax-advantaged accounts set up that you can use.
Custodial 529 Savings Plans
There are 2 types of 529 plans, the regular one and the custodial 529. 529 plans are state-run & tax-advantaged accounts that can only be used for education purposes. They are named 529 plans after the section in the IRS tax code they fall under.
A regular 529 has an adult as the account owner and the child as the beneficiary.
A custodial 529 plan has the child as both an account owner and beneficiary. The adult is still a custodian who manages the account till the child is old enough, but the adult is not the owner.
What does that mean?
The biggest difference happens if you have multiple kids.
A regular 529, since the parent is the owner, can be transferred between siblings. Additionally, for student aid (Free Application for Federal Student Aid, FAFSA) the totality of 529s accross all children is considered part of the parent’s investments.
A custodial 529 can not be transferred between siblings. And the account is considered the child, not the parents, account for FAFSA. So the custodial 529 is the child’s investment on FAFS and not taken into account for any siblings.
Regular 529 Savings Plans
Technically, there are 2 types, savings & pre-paid. The savings plan tends to be the one that gets the most focus as it is more flexible. I will largely ignore the pre-paid version here.
529 plans are state-specific. However, you can generally open 529s in any state, not just your state of residence.
The account owner will typically be the parent/person setting the account up with the child as the beneficiary. The owner chooses the beneficiary and controls what the investments are. Hence the parent can transfer the funds between children.
Anyone can contribute to a 529, so if you have friends & family who want to make contributions this is a wonderful way to allow them to do so.
The contributions are made with after-tax dollars and any earnings are tax-advantaged. If the money is used for education, the earnings are tax free. Lastly, if you have the unfortunate circumstance of living in a state with an income tax, you can likely get a tax deduction or credit on your state filing by contributing as well.
The money in a 529 can be withdrawn at any time and can even be applied to K-12 education if necessary
However, note that a 529 is subject to gift tax rules. Currently that is $15k limit (or $30k for a couple) in any given year.
[Note - There is a little bit of leeway if you want to do a 5-year gift tax averaging that allows a $75k ($150k for a couple), over a 5 year period. Ie- you can gift $75k this year and $0 for the next 5 years and still be under the gift tax limit.]
There are contribution limits on 529s. However the limits are fairly sizable. Even the states with the lowest limits have limits set at nearly $250k, and some states have limits over half a million. Therefore, the contribution limits shouldn’t be a limiting factor for most. If your kid is going to blow over $500k in out-of-pocket expenses on education (why????) and you have $500k to give, you likely are well enough off and likely are utilizing much more advanced tax avoidance strategies.
Also, 529s are transferrable between children. So if you fund one child’s college account and they don’t use it all, you can use it for other children. But take note, these accounts don’t expire, so if your kid waits till they are 40 and goes back to school (why???), they can still use the funds and get all the tax advantage.
Lastly, these accounts do get taken into account for student loans. Therefore, if you would qualify for aid/loans due to lower income, saving money in a 529 may result in you getting less than you otherwise would have.
ESA / Coverdell Savings Account
Education Savings Accounts (ESA) or Coverdell ESA is a trust that is very similar to 529s, but with plenty of restrictions.
You are limited to $2,000 per child per year contribution and you can’t make more than $110,000 or $220,000 if single/married filing. Therefore if you are a high-income earner, these are not an option. However, if you don’t have a high-income, these are another avenue for you to put some money away for your child.
The money you put into an ESA is after-tax and it grows tax-free, similar to a Roth IRA. If the account is used for education expenses, you can withdraw it tax & penalty free.
You can use this for K-12 education, private school tuition, text books, tutoring or vocational school.
Lastly, you are able to transfer the money from one sibling to another if one of your children ends up not needing it.
Child Savings Accounts at Banks
The least exotic option is a standard youth bank account. If you still get checks from relatives, even if you want to send that money off to one of the previous investment accounts, it tends to be easiest to deposit it to a bank first.
Most banks, especially local community banks & credit unions, have child-specific accounts with high-yields up to a low amount. We have accounts at a few different banks that offered 4% yields up to $1,000 or 3% up to $2,000.
Certainly not going to make your child rich with $40-$60 a year, but if you need to open an account at a bank anyway it makes sense.
Trusts
Trusts are a very big and general legal structure with a lot more uses than we have space to cover. In general, you can set up a trust on your own and there are templates out there, but this may be an area to work with a lawyer who specializes in the area.
Trusts are just legal documents where one person (the ‘grantor’), gives a second person the right to hold certain assets.
One of the biggest benefits of trusts is efficient transferring of assets on death. You get to avoid probate and all the public disclosures that come from it.
A benefit of a trust is it allows for more rules on the assets. You can set up rules around how and when the assets can be used. This is how ‘trust fund’ kids get their money.
We won’t get into revocable vs irrecvocable trusts here, but there is difference in control & taxes depending how you set up your trusts.
Wrapping Up: What Accounts Are Available For Your Child
We provided 8 different types of accounts that you can use for your minor child and introduced trusts.
Later this week we will go more in depth about how you can use the various accounts and some tips to better optimize where your money goes.
End of the day, any savings & investings you do for your kid will likely go a far way as they get older.
Any chance you plan on putting together a list like this for child income/how to pay your child and tax advantages?