Should you be investing in your kids’ future? Experts agree investing earlier takes the most advantage of the power of time.
Setting aside money for your child can set them up for a better financial future. And using the power of time and compound interest, your contributions could be enough to pay for college, buy a home, or even allow your child to retire early.
So the question is: how can you invest in your child’s future?
In this article, you’ll learn the importance of saving and investing for your child, the types of investment accounts to use, and what you must do to ensure your financial wellbeing.
Why is investing for kids important?
A key benefit to investing for your child is the years they’ll see time and the power of compound interest at work. Children can see how the money grows. And with economic changes and market outlooks evolving in every stage of their lives, it can be an excellent way to talk to kids about money, personal finance, and investing fundamentals.
First thing: Think about your retirement
Before setting up your kid’s financial future, have a plan for your retirement. Remember, you can likely use student loans for your child’s college, but you can’t take a loan for your retirement.
The following are some questions to ask yourself:
- Do you have a retirement savings plan?
- Are you contributing to your employer’s retirement plan like a 401(k)?
- Are you investing using Roth IRAs?
Think about how much money you’ll need in retirement. Many financial advisors recommend the 4% rule. You can live off 4% of your investments. For example, if you’re annual expenses are $40,000, then you’ll $1,000,000. Read more about investing for retirement.
Now, let’s go over the types of accounts with tax advantages to invest in for your kid’s future.
Step 1: Open a UTMA or UGMA account
As a parent or guardian, you can open a UTMA (Uniform Transfers to Minors Account) or a UGMA (Uniform Gift to Minors Act), which allows minors to open a savings account at any financial institution. The funds deposited into the custodial accounts are held in trust for the minor until she reaches the age of majority, usually 18 years old. At that point, the child can access the money. You can use custodial account funds for any reason.
Ther UTMA and UGMA accounts have no contribution limits. However, current IRS rules limit the tax advantages.
The UGMA account allows for only financial assets, while the UTMA account allows for any assets like cash or art.
Step 2: Open a 529 Plan to save for qualified educational expenses
A 529 plan is tax-advantaged savings account for college education. The money deposited into the account grows tax-free until withdrawn for qualified educational expenses. You can use the funds in the plan to pay for school tuition, apprenticeship programs, and student loan repayments. Financial aid eligibility can be unaffected by using a 529 plan to save for college.
A 529 savings plan works similar to a tax-advantaged account like a Roth IRA, where after-tax contributions are invested in mutual funds, exchange-traded funds, and other similar investments.
As a college fund, the money pays for qualified education expenses. Your investment can grow tax-deferred and be withdrawn tax-free. You are unable to deduct contributions from federal income taxes.
Even if you have a home state’s plan, you’re still able to use any of the many other plans available in nearly every state. The account owner can choose from various investment portfolios tailored to their risk tolerance and time horizon.
Step 3: Open a Custodial IRA
A custodial Roth IRA is a retirement account with tax advantages with contributions made with after-tax dollars. You can open a custodial Roth IRA for your minor child. The money grows tax-free until you withdraw it at retirement age.
With a custodial Roth IRA, you can invest your kid’s money into stocks, mutual funds, and ETFs.
However, your child must earn income from a part-time job like babysitting or a summer job like mowing laws. When he turns the age of majority, he will have full ownership of the account.
Your Roth IRA contributions grow tax-free, and there are no taxes or penalties on the amount contributed when withdrawn for any purpose. Additionally, investment returns are tax and penalty-free after the age of 59.5.
To open a custodial Roth IRA, you’ll need a brokerage account allowing you multiple investment options.
Step 4: Open a taxable brokerage account
A custodial brokerage account is a type of brokerage account where you hold securities for your child. It’s similar to a taxable brokerage account. You can invest in stocks, index funds, and bonds.
In this type of account, the child owns the assets contained within the account, but the parent has control of the investment decisions and any withdrawals.
It’s great to get your child started on the path to financial independence. Having custodial taxable brokerage accounts can be a great way to talk about investment options and money goals.
When to Talk to Your Kids about Money?
It’s essential to have conversations with your children about money. When creating an investment strategy, consider the steps mentioned in this article and involve your child in the execution. Teach your child about financial accounts you’ve opened for their benefit.