Whether you only have pennies to your name or millions in the bank, rearing financially successful children is an attainable goal that virtually every parent should strive to see come to fruition.
With the headlines in the news surrounding wealth inequality, many people have been persuaded to think that amassing wealth through innovation, entrepreneurship, or diligent saving is no longer something to strive to attain. However, for the financially literate, disciplined, and those that are willing to put in the work today and sacrifice for a future generation, certain steps should be taken to ensure – or at least encourage – the development of financially successful children.
Giving your children the tools necessary to survive in the modern economy is important, and certain financial steps can be taken now to increase the odds that your son or daughter will become a financial success and give back to their community and their own children.
Even if you have not achieved your desired financial status, you can still take several steps to construct the foundation of your legacy through your children. By teaching your children to save, invest, and avoid debt, you can provide the tools that will result in a better life for your own children and allow for the opportunity to build generational wealth.
Aside from learning and implementing a sound strategy in your own personal finance by avoiding consumer debt and paying off loans, investing in your 401(k) and Roth Individual Retirement Arrangement (IRAs) in well-performing mutual funds and index funds, you can also begin taking the steps to set up accounts for your children that will also serve as a way to teach your son or daughter about investing.
The best 5 accounts you should open for your kids are 529 Plans or ESAs, a Roth IRA, an account under the Uniform Gift to Minors Act (UGMA) or Uniform Transform to Minors Act (UTMA).
These accounts are investments that throughout the course of their lives, will generate returns beyond just financial measures. While if properly invested, these accounts will compound in meaningful sums of money, the primary goal should be to use these accounts to teach important financial lessons. By showing your children investing is important, you can help develop their mindset and shape what is valuable in their lives.
Why Parents Should Open These Accounts for Their Children
One of the greatest benefits that your children have is time for money to compound. Time allows for properly invested money in the market to compound and snowball into large sums of money that will aid them on their journey to become financially secure and independent.
As an example: How much money do you think would need to be saved and invested per month for a newborn to be a millionaire by the time they are 65?
The answer: At the historic market rate of return of 10%, only $12.89 would need to be put away on a monthly basis in an index fund that mimics the S&P 500 to reach that elusive millionaire status.
However, let’s say that you aren’t willing to invest the cost of lunch every month over their lives but quit contributing once your child turns 18. You would still only need to invest $18.88 per month in a mutual fund or index fund that gains the historic market return of 10% for your child to become a millionaire at 65. By investing $18.88 per month for 18 years, you would have $11,339 sitting in the account for your son or daughter on their 18th birthday. If no more money is contributed and the fund stays invested earnings 10% per year, after 47 years and by their 65th birthday, there would be over $1,000,000 in the account that you left as your legacy for the family – all for under $20 per month through age 18.
While setting up a normal brokerage account and investing the money with your son or daughter named as the beneficiary is one way to leave a legacy that secures your child’s financial situation, perhaps there are more efficient ways to invest in your children’s future.
Open accounts to save for their higher education
While having educated children will not guarantee they will become millionaires, the highest return on investment the vast majority of people can obtain is in themselves through furthering their education in a marketable field of study. Therefore, one of the best gifts that a parent could provide to set their children up for success is to fully fund their college education if their financial situation permits. Otherwise, putting as big of a dent in the cost of college is better than saddling your children with the full cost of tuition and living expenses.
Whether attending a junior college, 4-year university, or trade school is your child’s path, helping them save or ultimately, paying for their schooling without burdening them with debt is a massive gift that a parent can provide that will help to set them up for financial success. Once they graduate, they will be able to fully realize their starting salary completely unencumbered by debt service payments.
Currently, we are experiencing an unprecedented rise in student loan debt in the U.S. In fact, the total amount of student loan debt is over $1.5 trillion with the average borrower owing just under $40,000. While many in the political arena and media are sounding the alarms on the student debt crisis and questioning the laurels of higher education, statistics tell us a direct correlation exists between greater educational attainment and average salary.
In fact, an individual with just a high school diploma earns on average about $35,000 per year. While this may allow low income earners to scrape by, after expenses there will be little left to build wealth unless the cost of living is extremely low in their particular area. Those with an associate’s degree can expect to earn close to 20% more or nearly $41,500. Graduates from an accredited university with a bachelor’s degree will earn around $59,000 per year on average, and a master’s degree will correlate to an average salary of nearly $70,000 which is twice as much as a high school diploma.
Therefore, if you want to help set your son or daughter up for success, continually stress the importance of higher education and take the steps necessary to begin saving for their college expenses so they can graduate debt-free and not be ensnared with so many others in the student loan crisis.
Fortunately, there are several ways to begin saving for a child’s college education through tax-advantaged accounts. We’ll now examine some of the best methods to begin saving and investing for higher education through these selected accounts.
Open a 529 College Savings Plan
One of the best ways to save and pay for your child’s college is through a 529 plan. These plans typically come in two flavors –investments through index or target-date funds via savings plans or through pre-paid tuition credits.
Through pre-paid credits, parents are essentially locking in the cost of college courses at today’s prices. As much has been made about the ever-increasing cost of college tuition, purchasing credits at current prices means you will not have to worry how much the cost continues to rise since you have already paid for the credits in advance. Historically, college costs have risen around 8% per year. However, given the current political environment decrying the continuing rise in the cost of college, regulation or changes in policy could limit the benefits of prepaying for college if the inflation rate decreases.
The other type of 529 Plan is through the savings plan. Similar to a 401(k) Plan or other sponsored account, 529 Plans offer a certain, pre-defined mix of funds that range from target date funds which adjust the mix of stocks and bonds depending upon the length of time before the student enters university to basic index funds that track the S&P 500 or total stock market. Since the market has historically returned around 10% per year, the savings plan could result in the greatest financial benefit if properly invested and if market returns continue to produce similar returns.
As we will discuss further, you also have the ability to withdraw up to the amount of scholarships that are earned by the student without incurring taxes or penalty. The savings plan also allows for flexibility in what expenses outside of tuition qualify under the plan.
While contributions to 529 Plans are not deductible on your federal taxes, many states allow for deductibility for state income tax purposes under their specific plans. In addition to these benefits certain states offer, 529 Plans allow the money invested to grow tax-free with tax-free distributions for qualified education expenses. This characteristic allows 100% of your child’s college savings to continually compound without having to pay taxes on the gains or dividends, pending qualified use which includes tuition and associated fees, books and supplies, computers along with internet access, as well as room and boarding costs. However, if the account is tapped for non-qualified distributions, a tax and a 10% penalty will be assessed.
As an added benefit, if you are worried about putting away too much before you know if your child will be awarded scholarships or academic honors, you are allowed to withdraw the amounts earned in scholarships from the 529 Plan tax and penalty free. As an example, if you have a $100,000 in the 529 Plan and your student earns a scholarship that covers the full cost of tuition, room and board, and other costs, you could pull out the full amount from the 529 Plan without tax or penalty or transfer the balance to another child or qualified family member which includes the beneficiary’s siblings, parents, children, nieces or nephews.
Currently, there are no maximum annual contribution limits for 529 Plan, but before you load up on this tax-advantaged account, contributions to a 529 Plan will be considered “gifts” for tax purposes. In order to avoid taking a hit on your own personal taxes, you will need to keep annual contributions below the annual gift tax threshold. For 2019, this limit is $15,000 per person. Therefore, a married couple would be able to contribute upwards of $30,000 to a 529 Plan for their child without incurring any gift taxes on the contributions. However, if you do contribute more than the allotted amount, there is a way to circumvent gift taxes as 529 Plan contributions can be credited against your lifetime estate as an exemption, but the proper paperwork will need to be filed come April. If you are concerned about the tax implications, always consider seeking a qualified tax professional to assess your personal situation.
Additionally, there are limits on the total balance of 529 Plans which is governed by what the particular state’s plan considers the full cost of attendance. Once these limits are reached, no more contributions can be made; however, the balance can still grow beyond the limit without consequence. These limits vary, so research your state’s particular plan.
Considering that if you sent your child to college today, it will probably cost over $100,000 including room and board, supplies, and necessary expenses for your college student to go to an in state, public university, saving as soon as possible should be paramount since most families would find it nearly impossible to cash flow such a major expense. While the cost of college may seem extraordinarily high today, you also must consider that the cost of college has historically increased by 8% per year which means the cost of college has approximately doubled every 9 years. Therefore, if a family has a newborn today, based on historical inflation in college tuition and related expenses, the total cost of their child attending college in 18 years will be over $404,000. Therefore, a family would need to save nearly $22,500 per year just to send one of their children to the average 4-year university in 18 years, and for most families, this would greatly hinder other financial goals such as getting out of debt or saving for retirement.
If instead of delaying saving for your child’s college expenses, you decide to open a 529 plan and invest in an S&P 500 index fund, you would only need to invest $8,865 per year to pay for college in full. Diligently saving and investing from birth until their 18th birthday will cut your personal out of pocket expenses by over 60% and will making paying for your child’s college much more doable.
For most families, delaying saving for college will be a financially devasting mistake. For instance, if you delay saving and investing for college for just 5 years in this scenario, the amount that would need to be invested nearly doubles to $16,484 even though the child is only 5 years old and you still have 13 years before they head off to university. This drastic change is due to the fact that time in the market is the most important aspect for compounding returns.
If saving nearly $8,900 per year is still too much, there’s also another interesting strategy to consider. Even if you do not yet have children or your child has not been born, there is no reason you cannot go ahead and open a 529 Plan and begin contributing and investing. As a social security number is required to open the account, you can simply open a 529 Plan in your name and begin contributing money and investing before your child is even a thought. The main thing to consider is the gift tax implications previously discussed; however, in 2019, you would be allowed to gift the 529 Plan to your child upon their birth without incurring the gift tax as long as it is below $15,000, and even if the amount is above the threshold, you could file an exemption on your estate previously discussed. Ignoring the estate exemption, you could have up to $15,000 in a 529 Plan in your name prior to birth and then gift that amount to your child upon their birth. Without contributing a penny more, your child would have over $83,000 by the time they are ready for college. In order to fully cover the full cost of tuition previously discussed of $404,000, you would now only have to contribute $7,000 per year which would save you nearly $1,900 per year in saving for college.
Stressing the importance of furthering your child’s education through college or trade school from a young age is an important trait to engrain in their mind. However, encouraging them to saddle themselves with student loans to attain this education would be a terrible outcome to a well-intentioned suggestion. Therefore, starting the journey to save for your child’s college education will help them graduate debt-free and begin their own journey to millionaire status as they can use their higher than average income to begin investing.
Coverdell Education Savings Account (ESA)
Similar to 529 Plans, a Coverdell ESA can be used to save and invest to send your child to college to further their education and future career earnings without the need for student loans. The investments are allowed to grow tax-free, and the contributions and earnings can be withdrawn to pay for qualified college expenses tax-free similar to the 529 Plans previously discussed.
Unlike 529 Plans which are state-sponsored and impose no limits beyond the particular state’s generous “total cost of attendance,” Coverdell accounts can be opened with virtually any broker that offers the account option. Through a Coverdell account, parents have the ability to buy any fund or stock of choice. As 529 Plans typically offer just a cafeteria plan of options to choose, with a Coverdell account, you can choose a mix of stocks or funds that have outperformed that options offered by a particular state’s investment options – even if the state option provides a basic S&P 500 index fund.
However, if you are located in a state with an income tax and are contributing to a 529 Plan that qualifies, you would be allowed a deduction on your contributions for your state taxes; however, with a Coverdell, you do not receive this tax benefit on your state income taxes.
Another negative to consider for the Coverdell relates to the contribution limit. In 2019, contributions are limited to only $2,000 per year for each beneficiary. With the ever-escalating cost of college, you are unlikely to save and invest your way to cover the full cost of college like you could with a 529 Plan. Even if you invested $2,000 per year in a fund that outperformed the average historic market return by 2%, you’d still only have $111,500. As we discussed with a 529 Plan, you’d need to contribute nearly $8,900 for 18 years based on the average cost of college if historic college inflation continues at 8% per year.
Additionally, with a 529 Plan, you could front-load the investments, allowing the contributions to grow to the final amount that you have estimated would be necessary by the time college rolls around. Because of the low limit imposed by the Coverdell ESA, you would probably be best to contribute to a mix of the Coverdell and a 529 Plan if you would like to fully fund your children’s college costs. If you are content with knocking out a large part of the cost of college and believe you will have the ability to cash flow the rest of college when the time comes, a Coverdell ESA may be a decent alternative for college savings thanks to the tax-efficiencies and ability to choose the investment options.
Get them started with retirement using a Roth IRA
Besides saving for your son or daughter’s college education which will greatly enhance their earning potential, another way parents can jumpstart their children to the path of becoming a millionaire is by opening and funding a Roth Individual Retirement Arrangements (IRAs) or custodial Roth IRA for them. While there are no age restrictions for contributing to Roth IRAs, the caveat here is that the child must have an earned income, and they must meet the minimum age that brokers require to open an account. This could be 18 or 21 years old depending upon the particular broker which may require a custodian to oversee the account.
More than likely, your son or daughter will not make enough money to fully fund a Roth IRA as contributions are limited to the lesser of the amount of earned income or $6,000 in 2019; however, there is no reason you could not incentive them to invest and begin setting them up for financial success by offering to partially fund or match any contributions they make towards a custodial Roth IRA.
In fact, by opening an account for your children, you may peak their interest in investing and learning about the stock market which will put them decades ahead of their peers. Aside from the financial benefits of funding a Roth, the fact that earned income is required to contribute to an IRA means that they will be working and learning the skills necessary to hold a job in the marketplace. By contributing to good growth stock index or mutual funds on a consistent basis, they will be dollar-cost-averaging with each contribution and building the healthy habits of paying themselves first through their tax-advantaged Roth IRA while watching the account grow and compound over the years.
One of the greatest benefits of a Roth IRA is the fact that the invested contributions are allowed to grow tax-free, and withdrawals can be made tax and penalty-free at 59 ½ years old. While taking any contributed amount will greatly hamper the returns, Roth IRAs also allow individuals to withdrawal contributions without any taxes or penalty. This is because Roth contributions are not deductible for current year income taxes like Traditional IRAs. However, the benefits of the Roth IRA are derived over the decades of compounding and a completely tax-free balance. In 2019, the IRA contribution limit is $6,000, so we will use that figure for purposes of our analysis.
Let’s say you have a 15-year old who just started a part-time job earning $6,000 per year. They probably do not have enough cash or interest to fund a retirement account as well as put gas in their car for nights out or any other expenses they may have. However, because they made $6,000, with your help, they could open a custodial Roth, and you could fully fund their Roth IRA for 2019 if you have the financial means.
If this money was invested in an index or mutual fund that returned the historic market return of 10%, by the time your child reaches 60, they would have over $435,000 because of your one-time contribution of $6,000 when they were 15. If you continued to contribute $6,000 per year in your child’s Roth IRA from age 15 until they are 18, they would have over $1,500,000 by the time they turn 60 without investing another dime thanks to your $24,000 in contributions over 4 years.
Even if you do not have the funds to contribute the maximum amount, contributing even $1,000 from ages 15-18 into a Roth IRA will result in a tax-free balance of over $250,000 by the time your child turns 60 based on historic market returns.
While fully funding a Roth IRA would set your child up for success in retirement in virtually one fell swoop in their teens, maybe you are not comfortable simply handing your child a golden ticket and want that they have some ownership or skin in the investing game. There are obviously many different ways you can compromise with your conscience in order to at least partially fund this account. For instance, you could offer to match any contributions they are willing to make up to a certain limit, or even contribute just $100 on their birthdays or holidays throughout the year such as Christmas. Even if the light bulb has not fully clicked that investing offers a path to financial freedom and independence, at some point early on, they will come to realize how important sticking back a percentage of their money will pay massive dividends later in life.
Hopefully, you have used the Roth IRA as a financial lesson on compounding interest and as a reason to discuss the stock market, investing, retirement, and other personal finance topics with your teenager. These discussions could spur them into wanting to become a better investor for themselves or even consider a lucrative career in business or finance. Besides the actual invested contributions, there are many intangibles to consider as benefits to getting your children started as investors early on in their lives as they will have a greater understanding of the value of a dollar and time value of money. Even if they never venture from index or mutual funds into diving into the business and financial statements of individual companies, they will become more informed and well-rounded people by understanding the basics of investing thanks to your willingness to open a Roth IRA.
Consider Opening an UTMA/UGMA
Another way to invest on behalf of a minor is through an account thanks to the Uniform Transfer for Minors Act (UTMA) which is an extension of the Uniform Gift to Minors Act (UGMA). Under UGMA, minor children were only permitted to receive securities; however, the UTMA extension allows minors to receive items such as money, patents, real estate, and other gifts shielded from certain tax consequences. For our purposes, we will stick to the simplicity of investing in index and mutual funds.
These fiduciary accounts are custodial accounts which means while the account is in the child’s name and under their social security number, parents have control over the accounts until the minor reaches the age of maturity– typically, 18 or 21 depending upon the state and type of account. For tax purposes, the account is taxed at the child’s rate which offers significant advantages – particularly, if their parents are in higher tax brackets. However, due to certain “Kiddie Tax” rules, you won’t be able to use an UTMA as a tax shelter since after a relatively small threshold and under certain conditions, the parents tax rate would apply.
However, children generally do not have taxable income or have extremely low taxable income and tax rates, so there are obvious tax advantages to having a small amount of money in the UTMA. Taxes will probably not be levied on the dividends and capital gains, resulting in a larger portfolio as dividends and gains are allowed to compound.
Even though they are custodial accounts, that doesn’t mean UTMA money cannot be spent by the parent on behalf of the child. For instance, certain expenses like private school tuition or car purchases are permitted with UTMA money. Through an UTMA, you could anticipate future expenses and invest and grow any excess money you currently to offset these big-ticket items in a tax-advantaged account. However, once money is contributed, parents are not allowed to withdraw the funds unless its for these qualified purchases.
However, because of the custodial nature of the account, once the child reaches the state’s age of maturity for the particular account, control over the assets must be turned over to the child and the parents no longer will have any access or control over the money. If you’ve managed to save a fairly large sum expecting it to be spent wisely and your child squanders the savings, you could be inadvertently funding their poor choices.
Additionally, these accounts are considered assets of the child and could affect financial aid for college. There may also gift tax implications if the amount is large enough to exceed the annual exclusion amount for any given year.
An ordinary brokerage account could be a great option
The final account you could consider opening is a simple brokerage account in your own name that is earmarked for your child’s expenses or names them as the beneficiary. If you’ve already begun the process of saving for their college or don’t want too much money locked up in college savings, the child doesn’t qualify for an IRA because of their lack of earned income, or you have considered the pros and cons of an account under UTMA, a plain individual brokerage account may be a good way to fund and invest with the intention to benefit your child.
The benefits of a brokerage account are obvious for those already accustomed to saving and investing in the market. Thanks to capital gains and dividend treatment, income from these sources are typically taxed at a more advantageous rate compared to salary or earned income. However, a brokerage account is not nearly as tax efficient as a 529 Plan, Roth IRA, or UTMA.
For instance, if you bought shares of stock and held the shares more than one year, the gains would qualify for long-term capital gains treatment. For most, this would mean the gains are taxed at 0%, 15%, or 20% depending upon income. Dividends would also be taxed at these rates with the majority of filers falling into the 15% tax rate on ordinary dividends.
With a brokerage account you would have 100% control of the account, investment choices, and uses of the money. However, you would not have the tax efficiency offered by many of the other accounts previously discussed.
If you’ve already contributed the proper amount to grow into what your child would need for college or just want an account without any stipulations and do not mind sacrificing tax efficiency, an ordinary brokerage account that holds a mix of index and mutual funds or individual stocks that you’ve earmarked in your own mind may be a decent choice if you have the discipline to truly use the funds solely for your child.
Walking Alongside Your Child’s Journey to Financial SuccessI
Beyond taking the actions necessary to open a 529 Plan and/or ESA to save for college, getting your son or daughter started saving for retirement through a custodial Roth IRA, or by putting away extra in an individual brokerage account without any stipulations for use, the biggest contributor to rearing millionaire children is to instill the behaviors and mindset of becoming a millionaire.
By opening even one of the accounts mentioned and discussing the “why” behind saving and investing, you are demonstrating how valuable setting goals and consciously planning will help you achieve a greater life and future for your family in the long-term.
Through these accounts, you will have the ability to not only save and provide money for education and financial freedom in your child’s future years, but you will also have an incredible tool that you can use to teach your son or daughter about the value of a dollar and how you can accomplish anything with concerted effort and discipline.