I write a lot about how my wife and I are furiously saving for retirement. But, as my wife kindly reminded me, “what about the kids?! “
The pursuit of Financial Independence (FI) focuses on living below your means and reaping the rewards of compounding gains. If it is possible for someone who only started saving in their 30s to reach FI by then, can you imagine what is possible when their savings snowball starts rolling when they are born? So, let’s dive into the numbers and strategies and see what is possible.
My Story
I was extremely fortunate as a child in that my parents opened a mutual fund in my name when I was a year old. I believe they deposited around $1,500 into that account. Around the time I was in college, the amount had grown to nearly $20,000. That is one heck of a good start.
In fact, I attribute this “seed money”, if you will, to allowing us to have a shot at early FI… despite a Lost Decade of terrible spending decisions.
The Numbers
The power of compounding is truly magical. When you let it work for long periods it’s power can be astounding. Let’s look at what $1,000 invested for various time periods and a range of average returns can yield.
| Years Invested | 5% | 6% | 7% | 8% |
| 18 (College) | $2,406.62 | $2,854.34 | $3,379.93 | $3,996.02 |
| 30 | $4,321.94 | $5,743.49 | $7,612.26 | $10,062.66 |
| 40 | $7,039.99 | $10,285.72 | $14,974.46 | $21,724.52 |
| 50 | $11,467.40 | $18,420.15 | $29,457.03 | $46,901.61 |
| 60 | $18,679.19 | $32,987.69 | $57,946.43 | $101,257.06 |
| 70 | $30,426.43 | $59,075.93 | $113,989.39 | $218,606.41 |
Over the longer time frames, $1,000 generates enough gains to cover a year or more of living expenses! If your kid’s FI number is $2 million, then you could take care of 2 to 10% of their entire nest egg! And to think: The average return of the market over it’s history is about 10% (before inflation) so I may be conservative here!
Many of us left college with massive student loan debt. I left with about $40,000 myself. Just think… a monthly contribution of $100 over 18 years ($21,600 total) could have grown to cover this. College at about 50% off sounds good to me!
Investment Vehicles
Some of the most advantageous ways to invest for your kids include:
- 529 Account – named after Section 529 of the Internal Revenue Code, these plans allow tax free gains and tax free distributions when used for qualified education expenses. Almost every state has their own plan, and some plans offer additional tax benefits if you reside in the state you hold the plan in.
- Education Savings Account (or Coverdell HSA) – similar to a 529 plan, but also allows for additional K-12 expenses to be considered qualified expenses. ESAs have income eligibility limits ($190,000 for a married couple or $120,000 for a single person in 2019) and contributions are limited to $2,000 a year. ESAs may have a larger selection of investment options than 529 plans. They also must be used by age 30.
- Custodial Account (also known as UGMA/UTMA) – Created by the Uniform Gift to Minors Act and Uniform Transfer to Minors Act, these accounts allow you so invest for your kids with a certain portion of the investment income un-taxed while another portion is taxed at the child’s rate instead of the parents. While the tax benefits aren’t as good as the 529 and ESA, the Custodial Account may offer the widest array of investment options. And the perhaps the best perk… it doesn’t have to be used for education. This is the type of account my parents set up for me when I was a wee lad.
Allocation
With such a long investment timeline an allocation of 100% stocks is reasonable. For investment periods longer than 5 years, the odds of losing money in the market are essentially nil.
Picking individual stocks is always risky, but the time period of investment is so long, that companies will rise and fall, perhaps several times over. The biggest names today will not likely be around long into the future. Who heard of Google, Amazon, and Tesla 30 years ago? In fact, none of the original members of the Dow Jones remain there today. (G.E. was the last holdout and was booted in 2018).
All of this to say, that the set it and forget it approach of picking individual stocks for a 30+ year window is a dicey proposition at best. Maybe you have the time to devote to periodically reviewing and picking a handful of individual stocks. That’s great. I know that I don’t. Moreover, I don’t trust myself to make consistent good choices with stock picks.
It’s for these reasons I personally chose a total stock market mutual fund. A total world market mutual fund would also be a worthy consideration as well. You don’t need to worry about missing out on the hottest stocks… you will have them already! If one company goes bust (several will over this timeline), they will be replaced with a new one, and you won’t have to do anything.
Once your kid gets within about 5 years of needing the funds it is wise to transition the money into less volatile assets, such as bonds. This will reduce the risk of one market downturn wiping out all the funds right when your kid needs them. Presumably, as your children get closer to needing the money for retirement or other major life expenses they would have control of the account; however, the same concept holds true here.
Fees
When you are investing for decades, the importance of minimizing fees cannot be overstated. Many actively managed accounts have fees that total 1% or more. Look at the chart in “The Numbers” section and see the massive difference 1% makes. Remember that the market goes up and down, but fees are forever.
Consider Warren Buffett’s famous bet over a 10-year period that he could beat actively managed hedge funds using passive index funds. Spoiler alert: The bet concluded at the end of 2017 and Buffett’s passive index fund averaged 7.1% over the decade in comparison with just 2.2% for the fund of hedge funds.
Indirect Benefits
It’s clear that a little money invested early on can go a long way. But the benefits don’t stop there! Involving your kids in the setup of the investment accounts can be a powerful tool to help teach them finances and give them an appreciation of the power of compounding. Put another way:
-Albert Einstein
Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.
Our Plan
So what are we doing? We have elected a hybrid approach of combining two strategies. 529s for college and Custodial Accounts for retirement or other life expenses. When our accounts were with Edward Jones the 529s were held in Virginia’s plan; however, when we broke up with Ed we transferred these accounts to Missouri’s plan (our home state) which provides low fee index funds from Vanguard. All the accounts are invested in Vanguard Total Stock Market index funds.
Sadly, after the transfer to Vanguard, we have sort of neglected these 529 accounts. Now that we are finally able to max our 401ks we are discussing resuming some contributions. Alternatively, we did contribute money to their Custodian Accounts last year.
Our investment goals for the Custodial Accounts are a bit open ended; however, for the 529 plans we are targeting a balance sufficient to cover tuition, room and board at a 4-year state university. If they decide to go the Ivy-league route, then more power to them, but they will need to find means to cover the additional costs.
In Summary
Starting early can clearly make a huge impact. It may just give your kids an unbeatable head start to their financial future! Be sure to consider your investment vehicle choices, allocation, and minimize your fees. So what strategies are you taking to save for your kids?
Yes! We set up UTMAs for our two kids and plan to contribute $1000/yr to each. Actually the hardest part right now is that we don’t have $6k to fund minimums for VTSAX, so we need to wait/build that up.
They could get VTI with the amounts we’re contributing but I wonder if it’d be best to wait? But I don’t want to lose out on gains either! The ERs are the same so the only benefit VTSAX gives us is the ability to buy partial shares (which is nice indeed). I suppose we could build up to $3k each and then sell to buy VTSAX from then on? Any resources on how the mechanics of that could work?
That’s a great start and similar to what we did. To convert VTI to VTSAX you would need to sell your shares with the proceeds going into your settlement fund. This may take a couple days to “settle”. Then use the funds to buy VTSAX. It should be noted that if this is in a taxable account this would be a taxable event, so take capital gains into account.
I do like being able to buy fractional shares of VTSAX. For one taxable account we have in a similar situation, I am waiting for a down day when the VTI sale would realize little in actual gains.
Thanks, that is what I figured. There is a limit on capital gains tax for children in UTMAs isn’t there? Something like 0% until it’s above $1000 in gains or so? I think on the ChosoeFI podcast they said the account would need to be above $50,000 for that to happen which we’d be well below.
I think it is 0% on earnings up to $1,050. The next $1,050 in earnings is taxable at the child’s rate. Earnings over $2,100 are taxed at the parents rate. I found this here: https://www.troweprice.com/personal-investing/products-and-services/non-retirement-accounts/ugmas-utmas.html