Compounding interest is the gift that keeps on giving. It might be the best gift you can give your child.
There are a few ways to set your child up for a financial head start in the future.
DISCLAIMER: I am only just learning about investing for my child. So, take my advice with a grain of salt and do your own due diligence before investing.
Before you just start throwing money into accounts thinking you’re benefiting your child, stop and think about how you want to help your child.
Do you want to make the college burden easier, do you want them to have a nice down payment for a house or car by the time they’re old enough, or do you want to invest as a way to teach them about money?
As always, you have to figure out your why before you take action.
Let’s say you want to save for college. Let’s make it your goal for your child to graduate with less debt or no debt all together.
A 529 plan will be right up your alley if this is your goal.
A 529 plan can be incredibly powerful to set your children up to attend school with little to no debt.
You can set up a 529 account with yourself as the account owner and label your child the beneficiary.
If you have multiple children and one does not want to go to college, then have no fear. You can transfer the funds in the account to another beneficiary.
You are able to put in $14,000 into the account per year if filing single, or $28,000 if filing jointly without being liable for gift tax consequences. If you’re not worried about gift tax consequences, then you can contribute more depending on your state’s rules. This leaves a lot of room to really build the account and reap the benefits of compounding interest.
What makes a 529 plan so great, is that the money it generates from the capital you put in is tax-free. For example, let’s say I only put in $1,000 for the life of the account in a 529 plan, and it grows to become $5,000 by the time my son goes to college. This $4,000 is available to use for my son, tax-free.
However, there are restrictions on what the money can be used on. The use of the money must be for school purposes. That’s the whole point of the account after all right? So, you can use the money for things like tuition, books, room and board, computers, or printers. I would confer with the brokerage that you open your account with to see the extent to which you can use the money on tax-free.
If you choose not to use the money on school related endeavors, you will be penalized with a 10% tax on the earnings that you take out. So, it’s my recommendation you use it for school.
If your child graduates and still has money left in the account, fret not.
Do you remember when I said that these accounts are transferable to a different beneficiary? This means you can transfer the account to your next child. Don’t have another child? Why not transfer it to your grandchild?
To my knowledge, there is no penalty for transferring the account to another beneficiary. So don’t spend that money on $1,000 of pens just because your child is about to graduate.
College is not for everyone. It may be possible that your children fall under this category. Personally, I wish I had skipped college and went straight for a career. The degree hasn’t done much for me, but the life lessons have proven to be valuable.
Regardless, it’s ok if you’re child does not want to go to college. If this is the case, I recommend creating an account known as a Uniform Gift to Minors or Uniform Transfer to Minors (UGMA/UTMA).
These accounts are interest bearing custodial accounts that you as the owner control. It’s basically you taking money and investing it for your child in a broker account the same way you would do for yourself.
However, these accounts will not be in your name forever. Depending on your state, you will have to hand over the account to your child by the time they reach age 18-21.
So, this type of account may also be a great way to educate your child on the importance of a financial education.
Even if your child is uninterested in learning about finances, they will still at least have money at their disposal to start their life.
What makes these accounts so great is the flexibility that comes with them. You can pull out the money for anything that your child is in need of. Again, always check with the broker that holds your account to make sure you do not get penalized.
So let’s say your child turns 16 and is ready to start driving but is in need of a car. Guess what, you can take that money you saved for him/her in the UGMA/UTMA account and put it towards a car. Just make sure to put it in their name as that money has to be used for their benefit. Putting the car in your own name might make things difficult for you regarding the law.
The way the account works is relatively simple. You or your family/friends put money in and it is invested into securities such as stocks, bonds, and mutual funds. The idea is that these securities that you invest in will grow in value over time thus generating income for your children to enjoy.
There is no limit to what you can put in and take out. You could put in $100K today and take $50K of that tomorrow if you wanted for some reason. The same rule regarding gift tax consequences that applies for the 529 account, applies for this one as well.
Although the UGMA/UTMA is extremely flexible, it does have some cons.
Unlike with a 529 plan, the income generated in the UGMA/UTMA is taxed. This is where it gets slightly complicated. A portion of the income generated is tax-free, then the next portion of income is taxed at your child’s tax rate, then once both of these tax benefits have been fulfilled, the account is taxed at your own tax rate. So if we add number, the first $1,000 the account generates is tax-free, then the next $1,000 is taxed at your child’s rate, finally, everything else is taxed at your rate.
Another drawback compared to the 529 plan is that you cannot transfer this account to another beneficiary. It has to stay in the name of the child that you open it for.
Regardless, this type of account can be a great way to teach your child how to make your money work for you while building initial wealth for your child to start their life with.
I would highly recommend doing some more research on both plans and seeing the different pros and cons your state will allow for you. As stated before, I am no financial expert. It is something that I am extremely interested in. It is a tool that we can all use to help not only ourselves, but our children as well.
There are plenty more avenues out there to give our children a head start at life. However, these two methods are the easiest to get started with. Put money in and let the power of compounding interest help you set your child up for success.