Better Than a Piggy Bank: 3 Ways to Invest for Your Kid's Future
America is in an affordability crisis. From 1980 to 2023, college tuition, fees, room and board increased 885% (not accounting for inflation). At the same time, average home prices surged 577%, and today, a growing proportion of the population is unsure if it will ever be able to retire.
With no signs of these circumstances abating, it has become vital for parents to do whatever is within their means to financially prepare their children for a higher-cost future.
Fortunately, generational wealth does not require you to be a millionaire. Whether you're investing $100 a month or $1,000, what is most important is taking action. Because, as the adage goes, the best time to invest was 10 years ago. The second-best time is right now.
That notion is based on the time value of money, which suggests that a dollar is worth more today than hereafter due to its earning potential. Simply put, delaying investments now translates to missed opportunities then. When factoring for the compound interest that can be generated for your children over decades, that earning potential can be exponential.
These three tools can help you shore up your kids' financial futures.
1. Custodial brokerage account
While not tax-advantaged, custodial brokerage accounts — investment accounts for minors that are opened and managed by adults — offer numerous benefits, according to Hillary Stalker, executive vice president and financial advisor at CapWealth.
"Saving money for your children in any way, shape or form is never a bad thing," she says. "If the goal is saving for a car or a home, these accounts offer more investment options."
Most major online brokerages offer custodial accounts, but parents should be aware of the tax implications — particularly the so-called "kiddie tax." Although it was put into place to discourage wealthier investors from transferring assets to their children in order to take advantage of their lower tax rates, it affects income-producing assets for all tax brackets.
According to investment firm Charles Schwab, the kiddie tax applies to dependent children under the age of 18 (or full-time students younger than 24). It entails the following:
- The first $1,350 of unearned income is covered by the kiddie tax's standard deduction and is untaxed
- The next $1,350 is taxed at the child's marginal tax rate
- Anything above $2,700 is taxed at the parents' marginal tax rate
The gains from any stocks or exchange-traded funds (ETFs) held in a custodial brokerage account are not taxed until they are sold. However, dividend income produced by those positions is subject to tax in the calendar year the distributions are made.
Parents can use custodial brokerage accounts to grow funds for their child's future with wide-ranging applications, making them particularly useful for those who aren't sure if higher education is in the picture.
They also offer what Stalker refers to as the training wheels of investments — when your child reaches legal adulthood, the account transfers to their possession, affording them the opportunity to learn about investing and the importance of being a good steward of their money.
2. College savings plan
For parents who do see a pathway to college in their children's futures, a college savings plan can be one of the most powerful tools for preparing financially. That's because with skyrocketing costs, even higher-income households struggle with saving enough.
A study conducted by admissions consulting firm Spark Admissions, which surveyed 200 parents with household incomes over $200,000 and children ages 13 to 17, found that just 44.7% of families have saved or expect to save $100,000 or more. That figure falls short of the four-year, $110,692 average cost of college tuition, fees, room and board.
Enter the 529 college savings plan. "There's a lot more flexibility now with a 529 plan than there ever has been," says Stalker. "In the ever-changing education landscape, a 529 is going to give you tax-free growth that you can also use for educational expenses."
Qualified educational expenses include school-run housing, meal plans, books, computers, software, study abroad and transportation costs. They also include payments towards interest or principal on qualified education loans up to a lifetime maximum of $10,000 per designated beneficiary (and per each sibling of the designated beneficiary).
"The net for 529 plans has gotten much wider," Stalker says. "Now they can be used for private education in younger years, trade school, a traditional university and the expenses that come with college education as well as funding a Roth IRA."
That last component is noteworthy. Withdrawing funds from a 529 that have not been exhausted by qualified educational expenses typically incur a 10% federal tax penalty. The exception, however, is if that money is rolled over into a Roth IRA thanks to a provision in the SECURE 2.0 Act of 2022.
"The new rule allows you to roll up to $35,000 into a Roth IRA tax-free, which is an enormous benefit," says Stalker. "For people who have been fearful of what to do with money that's left over [in a 529 plan], that helps solve that problem."
There are, of course, conditions:
- The 529 plan must have been open for the designated beneficiary for at least 15 years
- The Roth IRA must be established in the name of the designated beneficiary of the 529 account
- The amount transferred from the 529 account to the Roth IRA is restricted by annual contribution limits
- The transfer amount must come from contributions made to the 529 account at least five years prior to the transfer date and the aggregate amounts transferred must not exceed $35,000 per beneficiary
There are additional uses for unused funds.
"A 529 plan can also roll to your next kid. If your oldest doesn't use all of it or doesn't go to school, you can always use those leftover funds for the next child. The same goes for a grandparent who opens one — they can use it for another grandchild," Stalker says.
While 529 plans do not have contribution limits at the federal level, each state has a lifetime cap that ranges from $235,000 to $575,000.
3. Roth IRA
Among non-retirees, 66% of Americans say they are behind on their retirement savings goals. Giving your child a head start can be achieved with a custodial Roth IRA, which can be funded long before you are able to roll over the remnants of a 529 plan.
Like a custodial brokerage account, parents can open custodial Roth IRAs as soon as their children begin producing income. That could involve dog-walking, babysitting or any number of summer jobs. They just need to be earning income and paying taxes on it.
Annual contributions are limited to $7,000 or the entirety of the child's income (if less than $7,000). So, for example, if your child earns $2,500 in a year, you can contribute up to that amount to their account on their behalf.
Custodial Roth IRAs — like custodial brokerage accounts — offer a wealth of investment options. Similar to 529 plans, which also use after-tax dollars, funds grow tax-free so long as withdrawals aren't made before your child turns 59 1/2 and the account has been open for at least five years. Ownership of the Roth IRA is then transferred to the child when they reach the age of majority.
"There's no wrong way to save," says Stalker. "At the end of the day, it really just depends on what your goals are."
Teachable moments
Another benefit to opening any of these accounts for your children is that it allows you to provide a model of healthy financial habits.
While children may be hardwired for the pleasure principle, establishing an understanding of how their accounts benefit from compound growth can convey the important of patience and persistence in investing.
"Children, like many of us, are naturally inclined to seek instant gratification," says Nate Hanft, senior vice president and financial advisor at Wealth Enhancement. "Creating an environment to encourage delayed gratification builds the discipline that will serve them well in their financial lives."
By utilizing these accounts, he says, parents can help their children develop financial well-being by involving them in those goals, emphasizing the importance of saving and instilling a sense of responsibility from an early age. These components are essential for children to understand the value of money and to set themselves up for financial success.
"It's no secret that children often mimic the habits they see," Hanft adds. "Financial behavior is no exception."
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