Stop opening bank accounts for Infants!
Let me explain why I say that.
Growing up my parents bought a life insurance policy on each of us and we each had a bank account that I only started using when I began driving. Once I had a debit card it was game over. I was all over the place, my spending was as frivolous as any other 16 year old and I was regularly broke (even though I was a Dollar Menu-naire). The life insurance policy was sold to them and (after speaking to them now) they didn't quite understand all of the terms when they first purchased it so it lapsed.
As a teen, I worked but I spent and I had no real idea about college. I knew I wanted to go but I didn't think anything about how much it would cost. Why would I? I knew how to write checks, tithe, donate to church and my bank account didn't overdraft often so I had it all figured out right? Wrong.
Trust me, as a parent now, who has worked a career in finance and is married with two kids, I don’t fault my parents. You don't know what you don’t know. If I had to do it all over again I'm sure I would have found some type of way to let them know that a bank account was the last account they should have opened for us when we were kids. Banking doesn't pique your curiosity like investing does.
Let’s break it down because there are 4 accounts you need to understand when investing for kids.
And we're talking about custodial accounts and other accounts that you can have for your child so that you give them a leg up in this world and invest for them. Because the earlier you do this, the more opportunities their money has to build on itself through compounding.
When our kids were only a few weeks old, as soon as we got their social security number, we opened up custodial accounts for them. Not custodial bank accounts. Custodial Brokerage accounts, meaning you could invest and buy stocks, mutual funds and ETFs and as they grow and pay dividends, that will compound and grow. A Checking account can only grow with a substantial interest yield.
And these were the building blocks in order for their wealth to start working for them. So that when they get to a certain age, they will be further ahead in closing the wealth gap. They have piggy banks but not bank accounts, I go more in detail about that in another article
There are four accounts that do much more than a bank account ever could for a young child and those are the custodial brokerage account, Coverdell account, a 529 Plan, and a custodial Roth IRA.
When a child is born, the least important account to open up for them is a bank account. Obviously they need to understand banking. I’ll never negate that. I personally just don't want my kids to have a bank account until they're teenagers. Think of it from this perspective, there is a cap on what you learn by banking, but when money is deposited in a brokerage account there is no cap on what you can learn about investing. Investing is a different conversation and a one that you need to start with your kid early. Even if you are struggling with investing yourself!
Whether it's a low interest rate environment or a high interest rate environment a child is in a position to assume the most risk of any investor because of the probability of them recovering from market risk (the value fluctuation of your investment). They have the most growth ahead of them and the most lessons to learn therefore it's only right that we allow them to make the most potential mistakes within reason. I'm not telling you to take a toddler skydiving, although when they jump off the couch it's pretty much the same thing.
I am saying that if you can there is someone in your household that has the ability to be greater than you it is your children. Don’t stifle their ability or growth by aiming too low. They have the access to information you transfer but only if you actually transfer it. Therefore, if you learned that buying a CD at your bank with a 2% interest rate does not yield much, you have to pass it on to your child so that they have an opportunity to pick the better risk-appropriate investment alternative.
In that same vein, if you own stocks in your account that are now “too risky” for your investment profile, there is nothing preventing you from transferring that investment to your child who, in theory, has a longer timeline and larger risk tolerance than you.
So what better account to start with than a custodial bank account?
How can I invest in a Custodial Brokerage Account?
The big takeaway for a custodial account is that it is the most flexible investment account for a minor. A custodial brokerage account is the same as an individual account would be for an adult. And in some states, or in most states, they're either going to be called a UGMA or UTMA meaning Uniform Gift to Minors Act or Uniform Transfer to Minors Act. And depending on whichever state, the age of majority would be 18 in most states, or 19, or even 21 in some other states. Just remember a gift made to a minor can not be taken back or transferred out of their name because the minor is protected.
But ultimately, once they hit that age of majority, it's completely theirs. Any money, assets in the account is completely theirs. There's no obligation for the money to be spent towards college or anything specific. They could decide to use the money for tattoos or to buy a car. There is plenty of flexibility but no control once they reach the age of majority. So, as a parent, it’s up to you to instill the right habits and lessons by that time.
Depending on where you have the account, you can buy whatever type of investment. So if it's held at a regular brokerage firm like Schwab, Fidelity, Merrill Edge, etc. they can own stocks, mutual funds, exchange-traded funds, CDs, bonds. There are plenty of investment options in a custodial account.
One additional point of flexibility that I like about custodial accounts is that you can transfer stock from your own account as a method of funding the account. So you can gift stock from your individual or joint account directly to your child's account which is considered an irrevocable gift. So it can never be taken out of that designation. It is going to be for your child. And that also goes for cash that's deposited into the account. And anyone, not even just you as parents, but anyone, so that's all relatives can decide to write a check directly to the child. You, as the custodian, could sign the back of that check and say, "As custodian for [Childs Name].” Investments in a minor’s account have to maintain some level of prudency so there's no borrowing on margin in the account and there are limits to the types of Options trading strategies you can perform.
If you're blessed enough to invest an unlimited amount just be mindful that amounts over $17,000 are subject to the gift tax. It’s also important to consider that assets in the custodial account are going to be factored into the Expected Family Contribution when it's time for your kid to go to college. Meaning it can reduce the amount they may receive in loans and grants for college.
What’s so good about Coverdell Education Savings Accounts?
A Coverdell Education Savings Account (Coverdell ESA) is designed specifically for education savings and is sometimes referred to as the “Educational Roth”. The contribution limit for Coverdell accounts is lower compared to other options. You can contribute up to $2,000 annually to this account, which can be invested in various instruments such as stocks, mutual funds, ETFs, and bonds, available through your broker.
When you withdraw the funds, the gains or growth can be used for qualified educational expenses, making it tax-free. Qualified educational expenses include tuition, books, room and board, and other materials related to school. It's important to note that anyone can contribute to a Coverdell account for a specific beneficiary. For example, if you open a Coverdell account for your son, his grandmother or aunt can also open their own Coverdell account as long as they meet the income limitations. Each person can contribute up to $2,000 towards the same individual's educational expenses, provided they meet the income requirements. Now let's move on to the next account for kids, the 529 plan.
What about a 529 plan for my child?
The key takeaway from the 529 plan is its potential for substantial education savings. It offers the convenience of a "set it and forget it" approach, even though the investment selection is somewhat limited. It's important to note that 529 plans are state-sponsored, meaning there may be variations depending on your state. Always confirm with your specific state's 529 plan website for details. However, as the account owner, you have control over selecting and changing the beneficiary.
For example, if you initially save for your daughter's education but she decides not to use the funds for college, you can switch the beneficiary to your younger son or even yourself if you decide to pursue further education. The growth of the funds within the 529 plan is typically tax-free when used for qualified educational expenses.
There are two types of 529 plans: the Prepaid and the Savings Plan. The prepaid option involves paying for a future college expense at today's prices (ex. 2023 prices for a college education that will start in the year 2034), while the Savings Plan option involves investing in a mutual fund. The latter is more common and offers a "set it and forget it" approach where contributions are made regularly and the funds grow over time.
Different mutual funds in the 529 Savings plan may become more conservative as the time for college approaches. While there's no annual contribution limit for 529 plans, it's worth noting that gifts over $17,000 per year may be subject to the gift tax. However, 529 plans allow for front-loading, enabling you to contribute up to five years' worth of the gift tax allowance (currently $17,000 multiplied by five). This means you could contribute a lump sum of $85,000 upfront, but you won't be able to make additional contributions for the next five years.
Furthermore, 529 plans offer flexibility in accepting deposits from relatives or other individuals who wish to contribute to your child's education savings. These deposits can be made directly into the account using a designated code or through online transfers. If you're unfamiliar with opening a 529 plan, you can refer to my video on how to open up a 529 plan.
What's this Custodial Roth IRA I Keep Hearing about?
Lastly we have the custodial Roth Individual Retirement Account (IRA). Yes, a retirement account for a kid is a thing. The key takeaway with the custodial Roth IRA is the flexibility it offers. The principal can be withdrawn tax-free at any time, and once your child reaches retirement age, the gains can also be withdrawn tax-free. This provides a tax-free head start on retirement, assuming you follow the necessary rules, which are not overly complex.
The custodial Roth IRA functions similarly to a regular Roth IRA, but it is specifically for children. However, you need to demonstrate that your child is employed and working, making it more suitable for business owners who have greater flexibility in employing their own kids. The maximum contribution limit for your child is $6,500 (2023), but it should align with their reported income. If your child earns $3,000, you can only contribute a maximum of $3,000 to their custodial Roth IRA. Similarly, even if they earn $12,000, the maximum contribution remains at $6,500. The real advantage of the custodial Roth IRA is that it allows tax-free growth until retirement, as long as the funds remain invested. It has the potential to compound over time, especially since the principal can be withdrawn tax-free. However, if left untouched, both the principal and future contributions will continue to grow and compound for the benefit of your child.
Once they reach the age of 59 and a half, they can withdraw funds from the account without paying taxes. When it comes to employing your child, there are various options depending on your profession. For example, if you're a hairdresser, your child can help with cleaning, and they can be paid for their work. Similarly, if you're a content producer or own a business where your child has a role, they can be compensated. It's important to consult with a CPA to ensure compliance with the tax code and be prepared to defend your employment arrangements in the event of an audit.
When you consider the available options for your child's account, there are custodial accounts, Coverdell accounts, custodial Roth IRAs, and 529 plans. In my case, my children have custodial accounts and 529 plans with plans for Custodial Roth IRAs. Ultimately, the choice depends on your specific circumstances and financial goals. Just know there are options out there and the choice is yours. Please don’t settle for only having a bank account for your child.
