Investments for Kids

I graduated from college with six figures in debt and no savings or investments. My first job out of college paid $400 per week. I ate dollar-menu fast food every day until I got sick and landed in the hospital. I paid $650 a month to live in a dank basement, ridden with bed bugs, and I slept on a mattress strewn on the floor. I hated my life.

I worked harder. I earned a 100% pay raise within two years. I worked nights to start a business. I ate healthier and exercised. I received an unexpected inheritance, and instead of spending the money, I put it in the bank and bought a copy of The Intelligent Investor. I grew confident in what I learned and invested that money during the financial crisis. I didn't listen to the people who told me it was a bad idea to invest in the stock market. I paid off all of my student loans within a year. My business failed and I took a low-paying job again. I worked even harder and was offered a better job at a 160% pay raise. I kept investing in myself, and when I was able to, I kept investing in dividend-paying stocks and low-cost funds. I can't complain about where I'm at now.

I'm telling this story because every child's future is a roller-coaster ride that we as parents cannot control. All we can do is give our kids a good start and teach them how to learn. 

To that end, here are a few things I've learned that I'd like to share:

Investing in General Education and Wellness

There is nothing more important than investing in oneself. It’s important to teach this to children from the start. The S&P 500 (an index of 500 large public companies in America) has grown about 8.00% per year, on average, since I started working; my salary has grown about 16.00% per year over the same period. The difference in these growth rates is shocking over time:

$10,000 growing at 8.00% over 30 years = $100,626.57

$10,000 growing at 16.00% over 30 years = $858,498.77

Paycheck growth is more meaningful than investment growth in the first half of life. It's important for children to get the best job they can and work hard in those early years.

Parents, take care - A family's health and wellbeing is most important. I know parents who don't go to the doctor or dentist in order to save money. Those parents are teaching their children a bad lesson. A serious medical condition costs more than a lifetime's worth of check-ups and wellness visits. (I once paid $20,000, out of pocket, to deal with the aftermath of an infected tooth.) Smoking, over-drinking or eating unhealthy foods can sabotage a child's future: How can a child succeed if he or she is taking care of sick parents?

Reading to children - A child is more likely to go farther in school if his or her household is filled with books. Phones and tablets don't count (though they have their place in education). Learning how to read is the first step in learning how to learn, the most important lesson of all.

Learning together - "What is money? Really." The world's smartest economists have a hard time answering that question. Meanwhile, many parents confidently answer: "Pfft, it's green paper that buys stuff." It's fun and enlightening to learn (or re-learn) things with our kids, and the internet makes it easier than ever to do so.

Teaching wants vs. needs - "I don't want to go to school. I need a fidget spinner." Kids say cute and funny things that grow less cute and funny over time. Teaching lessons about patience, gratitude and making tough choices is best done at an early age.

Starting a 529 Plan or Coverdell Account

There are two great reasons to open a tax-advantaged investment account for a child's education:

1. Money can grow tax-free as long as withdrawals are used for qualified education expenses; and

2. The money in these accounts, although earmarked for the child, can count as a parent’s asset (the federal financial aid formula treats parental assets more favorably than assets held in a child's name).

The earlier that a child starts investing, the better chance that he or she has to be successful at it. This is especially true when investing in the stock market.  

A Few Words About the Stock Market

I know a lot of parents who are afraid of the stock market. They think they're doing their child a favor by keeping money in the bank rather than "gambling" with it. Investing in the stock market is not gambling when an investor behaves responsibly. It's a way to become part-owner of the companies that we rely on. People who don't own a growing business -- or invest in growing businesses -- are more likely to grow poorer over time. 

The key to being a successful investor is to avoid making three major mistakes:

1. Paying for something that is worthless - Investors get burned when their investments completely lose their value (like a stock pick that goes bust). This is totally avoidable. Investing in a total stock market index fund like Fidelity's (FSTMX) or Vanguard's (VTSMX) lets an investor own thousands of America's largest companies in a one-shot deal. These companies form the backbone of America: They are valuable. This may be the safest and easiest way to invest in the stock market. Taken together, the companies within these funds will always be worth something. 

2. Overpaying for something that is valuable - People who bought a total stock market index fund at the market peak in October 2007 watched the value of their investment fall by 56%. The people who sold at the bottom turned an imaginary loss into a real (and devastating) one. The brave people who sat tight through the crisis watched their investment rebound and grow by more than 90% over the decade. Not bad for a "mistake." It sucks to overpay for an investment, but those who invest through the ups and downs of the stock market will ultimately pay a fair price in the end. This concept is called "dollar cost averaging." 

3. Panicking and treating something valuable as if it were worthless. Would a wise man sell his home to a stranger for pennies on the dollar because the stranger told the man that he had paid too much for it? Of course not. As we see in the example above, things can work out OK, even when an investor buys into the market at a bad time.

529 Plans and Coverdell Education Savings Accounts are two popular ways to save for college in a tax-advantaged way. Both plans have their pros and cons, summarized below:

	529 Savings Plan	Coverdell Education Savings Account
Income Limit	None	$110,000 for individual; $220,000 for joint return
Contribution Limit	Up to $14,000 per year before potential gift tax	$2,000 per year (until beneficiary turns 18)
Eligibility	Postsecondary education (i.e. college)	Elementary; secondary; postsecondary education
Investment Options	Offered by state (oftentimes, mutual funds)	Flexible (e.g. stocks; bonds; funds; CDs)
Impact on Financial Aid	Varies by owner, beneficiary and dependency	Varies by owner, beneficiary and dependency
Transferability	No tax consequences for qualified family transfers	No tax consequences for qualified family transfers
Age Limit	Varies by plan (usually no restriction)	Under 18 to open; must use by age 30
Federal Non-Qualified Withdrawal Penalty	Ordinary income tax + 10% (on earnings only)	Ordinary income tax + 10% (on earnings only)
Tax Deductibility	Varies by state; no Federal deductibility	None

I don't own a Coverdell ESA, so I can't speak from personal experience. A Coverdell account may be a good choice for new parents who plan to send a child to private school before college. Unfortunately, the stock market is not a good place to invest money that is needed soon, but a parent can use a Coverdell account to invest in predictable investments, like a certificate of deposit (CD). I prefer 529 plans because the annual contribution limits are higher and I get a tax break for investing in my state's plan. Almost every state offers a 529 plan and they range from great to terrible. I have experience on both ends of the spectrum. Here are key points:

1. Investors don't need a financial adviser to open a 529 account - Great plans are available directly and parents can save a lot of money by opening a self-directed account. 

2. Investors can choose any state's 529 plan - Morningstar rates 529 plans from best to worst. It’s a simple fact that most parents don’t live in the state with the best plan, so it pays to look elsewhere.

3. There is no reason to pay a sales charge or load - Paying for the right to invest in a fund is as ridiculous as paying an employer for a job. The best 529 plans offer no-load index funds that charge less than 0.50% in annual expenses (and much less than that, ideally). All fees that are less than 1.0% may seem small, but these tiny differences can add up to a small fortune over time. 

A Cautionary Tale (With a Happy Ending)

A financial adviser talked my grandfather (a NJ resident) into opening a NJ 529 plan even though the beneficiary (his granddaughter) lived in New York. That adviser pocketed a commission for giving my grandfather terrible financial advice. 

The NJ 529 plan, managed by Franklin Templeton, charged 5.77% up-front, plus 0.50% in annual expenses for managing an S&P 500 index fund. There were no tax benefits for anyone. That bad advice could have cost my family thousands of dollars over time. 

Fortunately, we minimized our losses by transferring the account to New York's 529 College Savings Program Direct Plan. The NY plan has no up front fees, it only charges 0.16% in annual expenses for high-quality Vanguard funds, and it offers tax breaks for New York residents.  

Considering Savings Bond Alternatives

There are two kinds of savings bonds available today: Series EE and Series I. Neither is a great investment because interest rates are so low. A $100 EE bond bought for a newborn child will be worth $102 when that child is attending college 19 years from now! EE bonds are guaranteed to double in value after 20 years, but that one-time adjustment only works out to a 3.53% rate of return (if an investor is patient enough to hold the bond that long). 

Series I bonds have a two-part interest rate: a fixed rate that never changes (right now it's 0%) and an inflation adjustment that is recalculated every six months. This "composite" rate is 1.96% right now: not nearly enough to offset the rising cost of attending college.

	Series EE	Series I
Minimum Purchase	$25 (for electronic bond)	$25 (for electronic bond)
Maximum Investment	$10,000 per year per Social Security number	$10,000 per year per Social Security number*
Earliest Redemption	12 months	12 months
Penalties	3 month's interest if redeemed within 5 years	3 month's interest if redeemed within 5 years
Interest Rate	0.10%	0.00% fixed rate + CPI-U based (inflation) rate
Special Adjustments	Value doubles in year 20; possible rate change for years 21-30	Inflation rate adjusted every 6 months
Compounding	Semiannual	Semiannual
Tax Deductibility	State and Local (and Federal, if qualified)	State and Local (and Federal, if qualified)
Impact on Financial Aid	High impact if held in child's name	High impact if held in child's name
*A taxpayer who receives an IRS refund that is $5,000 or greater can invest up to $15,000 per year in Series I savings bonds: $10,000 in electronic bonds plus $5,000 in paper bonds.

Savings bond interest is exempt from state and local taxes. Investors can avoid federal tax too if the redeemed bonds are used for qualified educational expenses (and if certain requirements are met). Bonds that are registered in a child's name have a higher (negative) impact on his or her eligibility for financial aid and will not qualify for federal tax exemptions. Grandparents, take note.

Parents who really want to invest in bonds on behalf of their children may find better interest rates and preferable financial aid treatment if they invest in a U.S. government bond fund within a 529 plan or Coverdell account.

Teaching the Right Lessons About Bank Accounts

Banks protect our money, insure it and help us access it from anywhere in the world. They are the keystone to modern life. But, most young kids don't need a bank account. Checks that are made out to a minor can be endorsed, cashed or deposited by a parent. Then parents can use that money to fund an education savings account (and maybe score a tax break by doing so). 

Bank accounts are not an investment. The days of earning 5% interest on a passbook savings account are gone. Bank accounts with low balances may cost more in fees than they pay in interest. Sadly, I know parents who still teach their children that putting money in the bank is how to grow rich.

Helping a child open a bank account as soon as he or she has an outside income (like babysitting money, not an allowance) is a stepping stone to growing rich, however. The money that a child earns can be used to fund a Roth IRA: a place where money can be invested and grow tax-free for life.

Remember, the more money a child has socked away in a bank account, the harder it becomes to qualify for federal educational aid. That's an important lesson to teach (or learn together with) a child, along with banking concepts like ATM fees, direct deposit, wire transfers, etc. 

Talking to Kids About the Financial Crisis

Kids shouldn't worry about banks stealing their money and neither should parents. That's not what happened during the financial crisis. The financial crisis happened because a lot of people acted foolishly, greedily and dishonestly (not just bankers).

Kids don't need to know the dirty details of the financial crisis. They just need basic guidance about money and life. The better our kids understand the basics, the less likely they are to make a big financial mistake or take guidance from someone who wants to rip them off.

Opening a Roth IRA As Soon possible

A Roth IRA can be opened at no cost and companies like Fidelity and Scottrade don't charge maintenance fees for having an account. However, a child may need a parent to open a Roth IRA.

It's tough to convince a teenage child to save for retirement, but it may be the most important financial discussion that a parent can have. Here's the amazing thing about investing in a Roth IRA: Investors get to keep all of the money. There are no taxes on dividends or capital gains. 

Holding a valuable investment like a total stock market index fund in a Roth IRA can be pure magic. I consider the Roth IRA the best thing that Congress has done for the American middle class in the last 50 years. Roth IRAs have no age limit, the money they hold doesn't count against federal educational aid, and very few children will earn enough part-time income to reach the annual contribution limit ($5,500 as of 2017).

A teenage kid with a summer job or part-time gig can contribute as much to a Roth IRA as he or she earns in a year, as long as the amount is under the annual contribution limit. A Roth IRA lets earnings grow tax free because the money put into the account was already taxed. But, since most teenagers pay little to no income tax to begin with, it’s a double win! 

Considering a Taxable Account

I can't think of a good reason to hold investments in a child's name within a taxable investment account. To do so opens the door to potential tax issues, estate planning issues and issues with securing federal educational aid. (I bet that a tax attorney or financial planner can think up an exception, though.)

What if a teenager or adolescent child becomes interested in the stock market and wants to start investing? It's an interesting situation with no right or wrong solution, but I'd take that interest seriously. People learn best when they want to learn. Maybe a high-schooler's investing experience is the thing that gets him or her into a top-rated university. It’s impossible to predict things like that.

Holding the right amount of cash

Cash is not an investment, but it is like insurance: It's great to have in a moment of crisis. I’d argue that everyone old enough to carry a cell-phone should have emergency money in his or her pocket and access to some kind of emergency savings.

Cash usually loses value over time; that's no accident. The U.S. Federal Reserve tries to manage the money supply so that it grows slightly faster than the goods, products and services that are available to us. America's central bank is trying to create a little bit of "inflation."

Why Inflation Is Such a Tricky Subject

Anyone can impact the money supply and inflation (albeit, in a very small way). Let's pretend that one friend lent another friend a few hundred bucks. Now, imagine those two friends unknowingly bid for the same item on eBay. The price of that item will go up; other sellers may increase their prices; as a result, buyers may increase what they are willing to spend.

And if one friend stiffs the other? Poof! That money has "disappeared,” and the friend who got stiffed may may not buy something else that he or she had planned to.

In short, money is a form of credit and credit is backed by trust.

Inflation can quickly turn into "deflation" if enough trust and credit goes poof all at once. That's what happened during the financial crisis in 2008. Trillions of dollars essentially disappeared because people realized their trust was misplaced. Prices fell sharply because the amount of money that people were willing or able to spend dropped more quickly than the amount of goods, products and services that were available.

Here are three important things to know about inflation and deflation:

1. No single person or organization controls the money supply;

2. An increase in the money supply doesn't make prices go up evenly (or sometimes, up at all); and

3. The U.S. government and Federal Reserve Bank are more afraid of deflation than inflation and will act accordingly.

Inflation is like a hidden tax that quietly picks our pocket over time unless our investments are growing faster than the inflation rate. The government-reported inflation rate is about 2% over the long term. At that rate, money will lose half its value in 35 years. I figure the inflation rate is closer to 4.5%, a rate that will cut purchasing power in half every 15 years.

Final Thoughts

I haven't written about trusts, pre-paid tuition, or the particular challenges that divorced or same-sex parents must endure. The same holds true for life insurance, which I don't consider to be an investment, but I do regard as an important part of a family's financial planning.

To be clear, this article is not personalized financial advice and shouldn't be treated as if it were. I believe that all of the information written above is true and accurate (at the time it was published), but facts and circumstances change and writers let their own opinions and biases into their work.