When and how should you start investing for a child’s future or education expenses? Laura goes over 7 great ways to help save for your kids.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.
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I receive many questions from parents about ways to invest for their children. Like this one from Nisha B. who says, “Thanks so much for your podcast. It's a big blessing and I have been religiously listening to it for a few years now. My question is, how do I open a crypto IRA or any other crypto account for my son, who is a minor with earned income?”
Thanks so much for your kind words and excellent question, Nisha! Today we’ll review various ways to invest for your kids and teens so they have a nice financial head start in life!
So, if you have kids or want to be a parent someday, don’t miss this important show. I’ll answer Nisha’s question by covering nine savings options for kids, plus, how they should or shouldn’t fit into your financial planning.
Hello, friends and thanks for joining me this week! My name is Laura Adams and I’m a personal finance expert who’s been hosting the Money Girl Podcast since 2008. I’m also the author of several books, including my most recent title, which was a No. 1 Amazon New Release, called Money-Smart Solopreneur–A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers. If you’re building a business or want to earn more income, I hope you’ll grab a copy of the paperback, ebook, or audiobook today!
My mission is to help you get the knowledge and motivation to prioritize your finances, build wealth, and have more security and less stress. I create every show to make sure you come away with practical advice that helps you make better money decisions and takes your financial life to the next level.
Parents often want to know what’s the best age to start investing for a child’s future or education expenses. While every parent wants the best for their kids, it’s also critical to make wise decisions for your own financial future.
So, whether you should save and invest for your kids or teens depends on your current financial situation and future goals. If you haven’t started saving for retirement or understand how much you must invest each month and year to achieve your dreams, that’s where you should start.
If you’re like most people, you’ll probably need a much bigger nest egg than you think. Yes, Social Security offers retirement benefits; however, for January 2022 the average payment was only $1,657.
The 2022 maximum retirement benefit depends on the age you retire and how much you earned during your career, but for most people, you’ll want to have some savings to supplement your Social Security income and cover increasing medical costs.
So, parents should never forgo saving for their own retirements to pay for a kid's college or any other significant expenses. Instead, create a financial plan that includes investing for yourself and your kids when you start a family. The sooner you begin saving for short- and long-term goals, the less stress you'll feel emotionally and in your budget.
If you get a late start and can't afford to save for a child, don't feel guilty about it. Remember, putting retirement first is in your entire family's best interest. If you sacrifice financial security for your kids, you may find yourself relying on them to support you in your old age!
While it might seem coldhearted for a parent to refuse to save or invest for a child, don't forget that kids have options, such as working, getting education scholarships, and taking out federal student loans. But there aren’t any loans or grants to support you after you stop working.
Therefore, if you're less than 20 years from retirement and haven't reached 80% of your savings goal, stay exclusively focused on building your retirement nest egg.
Everyone, including parents, should save at least 10% to 15% of their gross income for retirement before saving for your kids. Always shore up your financial well-being first, even if that means saving nothing or less than you'd like for your kids.
Remember that if you’re a good saver, you might end up with a surplus and could help out a child by paying off their student loans, other debts, or leaving them an inheritance down the road.
When the time is right to save and invest money for your kids and teens here are seven options to consider.
1. Use a bank savings account.
An FDIC-insured bank account is one of the safest places to save for a child. However, even though high-yield account rates have risen to about 2% as of September 2022, that’s a relatively low amount, which also gets taxed as income.
For example, if you save $100 a month for 40 years in a bank account earning 2% interest, you'd accumulate nearly $75,000. But if you invested the same amount and earned an average of 10%, you'd have almost $650,000 after four decades.
The upside of bank savings is being entirely safe from investment risk. But in exchange for safety, banks pay little interest. That means you could be leaving many thousands of dollars on the table compared to investing the funds in one or more of the options I’ll cover.
Also, depending on your child’s age, there are various innovative kids banking apps and debit cards that offer:
And speaking of allowances, you might be interested in how the going rates vary. You can enter your state, child’s age, chore type, and even their savings goals in the Kids Chore Calculator to learn more.to determine how much to pay your kids for completing their chores.
2. Open a 529 college savings account.
If you’re interested in saving for a child’s education, investing through a 529 college savings plan is an excellent option. With a 529, you make contributions and choose how to invest the funds from a menu of options, such as mutual funds. There are no income limits and most offer high annual contribution limits, such as over six figures.
If you use 529 funds to pay qualified education expenses–such as tuition, fees, books, required equipment, and room and board–they’re tax-free. You can spend a 529 at U.S. accredited schools and even some foreign institutions. You also don’t need to choose a 529 plan or a college from the state you reside in. For example, you could live in Florida, participate in a New York 529 saving plan, and use the funds to send a child to college in California or abroad.
Thanks to the Tax Cuts and Jobs Act of 2017, you can spend up to $10,000 per year tax-free on elementary and secondary school expenses. That gives parents the flexibility to withdraw funds for tuition and other education expenses for a younger child attending a public, private, or religious school.
Each state sponsors their own 529 plans, and some offer a deduction for contributions made by residents on their state income taxes. The fees and benefits—such as the maximum contribution limit, investment options, and in-state tax benefits—vary considerably, so it’s critical to shop and compare plans.
The only downside to a 529 is taking withdrawals used for non-qualified expenses means you must pay income tax, plus a 10% penalty. So never put more in a 529 than you estimate your child will need for their total education expenses. Also, note that you can't start funding a 529 until your child is born and has a Social Security number.
3. Enroll in a 529 prepaid tuition plan.
Another way to save for a child’s education without taking any investment risk is a 529 prepaid tuition plan. They allow you to save money by locking in today's tuition costs for the future, instead of investing today’s dollars to make up for rising costs and inflation.
Prepaid plans are offered by certain institutions and states. There's also a national Private College 529 plan you can use no matter where you live to lock in tuition at hundreds of private colleges and universities across the country.
When you open a prepaid plan, you must name your student, who is the beneficiary. But you don't have to pick a school until your student is ready to enroll. You can even change plan beneficiaries if you have another potential student in the family.
You can even have a 529 prepaid plan and a 529 college savings plan for the same child. Your prepaid account would cover tuition, and your savings plan would pay for other qualified expenses, such as room and board, books, supplies, and computer equipment.
The major downside of a prepaid plan is if the beneficiary wants to attend a school that accepts only a portion or none of the funds. In that case, you must pay the tuition difference out of pocket and may not get the total value of the plan.
4. Contribute to an IRA (individual retirement account).
A little-known benefit of an IRA is that kids can have them, too. You may see an IRA for a minor called a custodial or guardian IRA. It must be in your child’s name (and can’t be owned jointly), but you or another adult will manage it until the child reaches the age of majority.
The primary IRS rule you must follow is that minors can only have their own IRA if they have allowable earned income, including:
Therefore, IRAs are only available for teens with a part-time job during the school year or full-time work during the summer. You can’t fund an IRA for an infant or toddler who can’t legitimately earn income–unless you have a baby genius or star of a diaper commercial!
Nor can you pay an allowance to a young child and call it income for the purposes of an IRA without proper documentation. You must have proof that income taxes are paid on a child’s income for it to qualify for an IRA. As I mentioned, scholarships and grants for college students count as income for IRA purposes, but only if they’re taxable.
While self-employment income qualifies minors for an IRA, you must file an annual tax return with Schedule C to record business income and expenses. And no matter your age, if your business earns $400 or more, you must also pay self-employment tax, which covers Social Security and Medicare, using Schedule SE.
In other words, if you pay a child for doing work like babysitting, errands, or snow shoveling, and want to claim it as their business income, keep detailed records so there’s no question about its legitimacy.
Note that even though your child must have earned income to be eligible for IRA contributions, the deposited funds don’t have to come from their bank account. A parent can fund a kid’s IRA up to the amount their child legitimately earned during the tax year.
For 2022, the IRA contribution limit is allowable earnings up to $6,000 (or $7,000 if you’re over age 50). Here’s an example: If your teenage child is a summer lifeguard and earns $3,000, they’re eligible to contribute up to $3,000 in an IRA for the tax year.
But if a child earns $10,000 busing restaurant tables, they could only contribute the maximum of $6,000. And in years when a child has no earnings, no IRA contributions can be made.
You can open a traditional or Roth IRA for a child. With a traditional account, taxes on contributions and account earnings get deferred until the child takes future withdrawals.
However, since kids typically don’t earn enough to benefit much from an up-front tax deduction, using a Roth IRA is usually a better choice.
With a Roth IRA, contributions are taxed upfront but withdrawals in retirement are entirely tax-free. That allows your child to avoid paying tax on decades of growth in the account, which is a fantastic benefit!
While there are annual income limits to qualify for a Roth IRA, most kids earn much less. For 2022, single taxpayers earning less than $144,000 can make Roth IRA contributions. Again, that income threshold only applies to the child, not their parents or the account manager.
In addition, after your child has owned a Roth IRA for five years they can withdraw previously taxed contributions (but not the untaxed earnings portion) before the official retirement age of 59.5 without paying taxes or an early withdrawal penalty. That flexibility means your child’s money could be used for any purpose they like, such as paying for a car, house, travel, or college.
Of course, it’s best to leave retirement accounts alone so they grow as much as possible, giving a child a significant financial head start. Young investors have a tremendous mathematical advantage when they leverage the power of compounding to build wealth. But when kids have a Roth IRA, they have the ability to tap their balance early if absolutely needed.
5. Open a crypto IRA.
Now, we’ll get back to Nisha’s question about opening a crypto IRA or other crypto account for her son who has earned income.
After you open a retirement account, you must choose investments to own inside it. You might put 100% into one fund or split up contributions into preset percentages. Many investment firms offer a dizzying array of options including stocks, bonds, CDs, money market funds, mutual funds, and exchange-traded funds (ETF).
Now, with the growth of cryptocurrencies, there are IRAs exclusively offering them. A traditional or Roth crypto IRA has the same rules as a regular traditional or Roth IRA. But you have the ability to choose various cryptocurrencies, such as Bitcoin and Ethereum, from the investment menu.
If the value of coins in a Roth crypto IRA explodes by the time your child retires, they’d completely avoid paying tax on all that investment growth in the account, which is pretty sweet.
RELATED: 8 Pros and Cons of Investing in Crypto in Your 401(k)
6. Contribute to a brokerage account.
But what if you want to invest for a child that doesn’t have earned income? You can open a taxable brokerage account for that purpose. It would be in your name, as minors can’t own taxable investments and financial products in their names.
However, you can create a custodial account known as a UGMA (Uniform Gift to Minors Act) or UTMA (Uniform Transfer to Minors Act) at most banks and brokerage firms. These special accounts allow investments for minors to be held in the care of an account custodian. When they become an adult (usually 18 or 21, depending on your state), the trust assets automatically transfer into the child’s name.
The main benefit of using a UGMA or UTMA account is that you can give a child as much money or assets as you like. There are no annual limits, and you can also withdraw funds at any time and for any reason. A portion of the account's investment earnings gets taxed at your child's income tax rate, which can reduce taxes.
The downside of UGMA and UTMA accounts is that once the child reaches the age of majority, parents have no control over how the child spends the funds. Also, custodial accounts are considered an asset of the child, which means they're a more significant factor in the calculation for college financial aid than if owned by a parent.
7. Get a life insurance policy.
An often-overlooked way to protect a child's financial future is buying life insurance. Every parent should have life insurance so their minor children would be financially secure after their death. It pays one or more beneficiaries after the policyholder's death.
There are two main types of life policies, term, and permanent. Term coverage pays a cash benefit if you die within a period, such as 10 or 20 years. And permanent coverage applies no matter when you die, and it typically accumulates a cash value.
The downside of life insurance is that it typically doesn't provide a benefit until the policyholder dies. However, if you have a permanent policy that builds enough value over time, you could tap it to pay any expenses you wish for a child.
Nisha, thanks again for your question and I hope this show helps you understand various options.
If you have a money question or a topic suggestion, visit LauraDAdams.com and email me using my Contact Page–or leave a voice message at 302-364-0308. You can also visit LauraDAdams.com to learn more about my work, books, and money classes.
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That's all for now. I'll talk to you next week. Until then, here’s to living a richer life.