As a woman of color and someone who grew up without much financial security, I can tell you proactively planning for your children’s financial future matters a lot. It could be the difference between having to work as soon as you are legally able to versus being able to be a “kid.” It may be the difference between freely choosing the university that is an excellent fit for you personally and academically or choosing the cheapest one.
Or it could simply be the ability to actively choose where you want to live once you leave home.
As a financial advisor, I’ve spent lots of time helping my clients decide how to invest for their children. I’m also a mother who has decided to invest for my three girls. I know it can be a difficult decision to navigate, and I want to share some tips with you as you decide how you can begin with confidence.
I’ve found that a desire to provide better for our children is almost universal in my work as a financial advisor. I have yet to find a parent who didn’t want to give a better financial start in life for their child than they had.
I find most parents don’t know how to start or how exactly to decide between the myriad options out there. I want to walk you through the options and give you the tools to determine which might be right for your family — after all, finances are not a one-size-fits-all game.
1. A High Yield Savings Account
I generally recommend everyone have a high yield savings account. These are low-risk ways to make money on your money than other conventional types of savings accounts because the APYs on these are higher. For example, many high yield savings accounts right now are offering .50% APY, or an expected rate of interest earned over a year.
I typically advise against selecting savings accounts at regular brick and mortar banks for several reasons. Firstly, they currently earn a very low-interest rate which does not allow your hard-earned money to grow. Secondly, there is no inherent tax benefit – short or long term. These types of savings accounts usually have .01% APY, which is exponentially smaller than a high yield savings account.
If you do utilize a traditional savings account, I recommend opening that high-yield savings account instead of a regular one. This way, you earn more interest on your hard-earned money.
2. 529 Accounts
There is no shortage of headlines highlighting that higher education costs are highly stressful and intimidating for parents. Besides clothing, feeding, and housing your children, it has to be one of the highest costs you will incur as a parent (or your child in the form of debt upon graduating college). Student loans are a significant burden for millennials, but our children don’t have to bear the same struggle. By opting to save for our kids’ education in a tax-advantaged 529 investment account, we can financially prepare ourselves and our children for college or graduate school. You gain all the benefits of investing and preparedness by consistently contributing a small amount, allowing compound interest to grow the balance over time (if appropriately invested), and never having to pay taxes on the earnings if the money is used for qualifying education expenses.
State-specific tax breaks are a bonus of 529 plans. 30+ states currently provide some measure of a tax deduction for 529 account contributions. If you’re fortunate enough to live in one of those states, then selecting a 529 plan is a win-win for you and your kids– they have dedicated funds to put towards their higher education, and you reduce your state tax bill. A little bit goes a long way here, so don’t feel as if you need a whole lot of money. Even $25 a month for a newborn baby can add up.
I generally recommend parents save no more than 75% of the anticipated college costs to allow for any merit or financial-based student aid or grants. You do not want to have too much money tied up in these.
529’s might be for you if you want to reduce taxable income, have a longer investment time horizon, and enjoy the benefit of tax-deferred growth. It is especially beneficial if you feel strongly that your child will attend a private school for elementary, middle or high school education or attend college.
3. Custodial Roth IRA account
A custodial Roth IRA is just like a regular Roth IRA, but dedicated to a minor child earning income. It is subject to the same contribution limits as regular Roth IRA ($6,000 in 2022) and income limits (2022 MAGI of under $144,000 for single filers or $214,000 Married Filing Joint filers). Your child needs to have earned at least the amount you contribute from a W2 or 1099 job in the year you make the contributions. For example, if your child earns $4,000 from a summer job, you can contribute up to $4,000 for the year into a Custodial Roth IRA. Many parents I know will implement a matching contribution plan with their kids. You put in $1, I’ll put in $2.
This is a really cool account to utilize for you business owners out there. You could potentially hire your child to work in your business and put that income up to $6,000 into a custodial Roth IRA. Be sure to consult your tax professional about this and document hours worked, responsibilities, and reasonable pay for similar roles in your area before implementing.
I believe in balancing short, medium, and long-term financial goals and don’t want to see too much tied up in highly long-term focused accounts for young children. It is an incredible way to let the wonder of compounding interest do its thing as the funds are contributed after-tax and can grow tax-free for decades.
However, I usually only recommend these accounts if parents are already saving for higher education expenses and are not a good candidate for a Custodial UTMA account. I believe in balancing short, medium, and long-term financial goals and don’t want to see too much tied up in highly long-term focused accounts for young children.
A custodial Roth IRA account might be for you if you have an older child who is already earning an income, or you have already set up a 529 or UTMA account for your child’s benefit.
4. A Custodial UTMA or UGMA account
These accounts are indeed a great, flexible option for those parents who want their children’s nest egg to grow but don’t want to restrict those specifically to education-related expenses.
Essentially a UTMA or UGMA account is akin to a brokerage or taxable investment account for minor children. Since children are not eligible to directly own property, UTMA accounts allow parents to invest for their children’s future while they are young. You have access to all the investment options you can imagine — unlike 529 plans. Your state of residence will determine the age your kid will be able to access the funds however the age of majority for most states is generally 18 or 21 years old.
A primary, understandable concern I hear from parents when considering setting up a UTMA or UGMA account is handing their children large sums of money immaturely. I completely understand that concern.
After all, we know how unsavvy we were with finances at that age. However, I view it as a fantastic opportunity to prepare them for adulthood and learn to manage money well. Engaging in ongoing discussions with them from a young age on how to handle money is crucial for long-term financial success and breaking generational cycles. I think UTMA and UGMA accounts are an excellent opportunity to do so since you will be forced to make the funds available to them at the “age of majority” — whether you like it or not.
No matter what investment account you choose, use this time to have money conversations with your kids. Showing them the value of hard-earned money will help them in the future.
A critical note about UTMA accounts is that capital gains, dividends, and interest accrued in them are taxable to the child’s parents regardless of who owns the account. However, these accounts are tax-free or taxed at a low “kiddie” rate for the first $2,200 of earnings (in 2021).
Custodial UTMA accounts might suit your family if you want to invest your contributions, you have an investment time horizon of 5+ years, or you don’t want to restrict your money to a dedicated education-focused account.
If all this information feels overwhelming, don’t fret! Do your research and pick whichever option you intuitively think is suitable for your family. You can’t foresee every potential hiccup of these accounts or what the future holds for your kids. However, I am confident that you will be glad you started somewhere, albeit imperfectly.