Last Updated on
With the amount of debt in our society, it is our job as parents to give our children the necessary tools to be successful in life – especially when it involves money.
If you’re anything like me, your parents taught you only the basics of money. How to manage a checkbook, don’t spend more than you make, etc. I did not know anything about investing when I entered adulthood, but I knew how to avoid debt. I now have 3 children of my own and I want them to be equipped with the best advice and life lessons I can give them in regards to money – especially investing.
When my children were younger, my wife and I opened savings accounts for each of them at our local credit union. For each birthday and Christmas, family members would send my kids cash and checks as part of their presents. We would usually take part of the money and deposit it into their savings account so my kids have a lump sum of money when they get older. Part of the money they are allowed to spend on toys and games, but we started a habit of saving a portion of the money in a savings account.
The more I learned about finance, the more I did not like the thought of my children’s money sitting in a savings account. Each year we put more money into it and each year, due to inflation, the buying power of that money is worth 2% less on average. If my kids are not going to use that money for 10+ years, imagine how that compound deflation would take a toll on their money!
Rather than leave the money to sit there and depreciate, I moved the majority of their money over into a custodial account invested in index funds so it would earn interest while they are young. What is a custodial account? I’m glad you asked!
What Is A Custodial Account?
For the purposes of this article, we are going to talk about mutual/index fund custodial accounts. It is an investment account that an adult controls for a minor up to the age of 18 – or in Arizona, up to the age of 21.
I control my children’s custodial account and they can not make any changes or withdraw from it without my consent until they are 21 years of age.
I am the custodian and I chose how to invest my children’s money. For my kids, I chose a Charles Schwab account and I invested their money in low-cost index funds. By investing in low-cost index funds, I greatly reduce the number of fees that have the potential to eat up their profits. While some people view stocks as risky, I am not worried about it due to the amount of time I will let the money sit.
This is called the buy and hold strategy. I put their money in and I let it sit no matter what the market does. Investment strategies will be discussed in much greater detail in a future post, but for right now, the best advice I can give you is, invest it and don’t touch it!
Why Should I Open One For My Kids?
With custodial accounts, there are no income limits, contribution limits, or withdrawal penalties. In the future, if you want you can also move this money out of the account and into a 529 plan (tax-advantaged college saving plan/a.k.a. qualified tuition plans) as they near college age.
Here is a simple example of why it makes sense to invest your kids’ money. If I put $1,000 of their money into an S&P index fund, their returns will likely average around 8% a year – based upon historical returns. If I put that $1,000 in and left it alone for 10 years – and I didn’t add another penny, their money could have grown to $2,158.92 at 8% compounded interest.
Now, this certainly isn’t going to be something they can retire off of, but it serves two primary purposes.
- The money I invested for them when they were young, could have easily doubled giving them that much more to spend and invest in the future.
- The most important purpose? This is an excellent opportunity to teach your kids about compound interest and investing! Rather than simply talking about investing, your kids can actually see how investing and compound interest has affected their own money. It is right there in front of them and they can choose what to do to with the account in the future. They can withdraw funds for things such as a car or other items, or they can leave it sit and add to it.
But What If The Market Crashes And They Lose Everything?!
Market dips and crashes do happen from time to time, but historically, every crash has resulted in a recovery – and then some. What about 2008??!! 2008 was a scary time for most investors.
But do you know how long it took for you to recover your losses after that dip? If you didn’t touch your investments (providing they were in an index) and let them sit, it took just four and a half years to fully recover¹ – that’s it. While it was scary, the crash quickly recovered and the market transitioned into the longest bull market in history-making significant gains for investors.
I do agree that losing money is scary. I thought about this with my kids’ accounts as well. My kids do not have tens of thousands of dollars invested so in the worst case scenario, if the market totally tanks when they need or want the money, I will give them the money that I initially invested from my own cash reserves.
I will leave their money invested and wait for their accounts to regain their investment momentum. This is a very unlikely scenario, but I planned for it just in case.
Disadvantages Of A Custodial Account
To be totally transparent, there are a few things you should know when it comes to custodial accounts. Because the account is also in your children’s name, it has the potential to reduce the financial aid eligibility for your children in the future. Schools expect that 20% of the investments in a custodial account should be used for education.
You do not have to use this money for education, but this is how financial aid is calculated. This may impact their financial aid eligibility by 20% of what they have invested. In addition, there are tax implications you need to be aware of.
As of 2018, when the account earns interest, each year the first $1,050 in gains is considered by the IRS to be “tax-free” and the next $1,050 is taxed at the child’s rate – which is a 10% federal income tax. Anything above those amounts is taxed at the custodian’s (your) tax rate. The amount you have invested for your children will determine how much interest is earned and how many tax implications there are.
Even with the tax concerns, your child’s money is still earning much more than the measly .06% their savings account would pay.
Gifting To The Account
Parents and Grandparents are allowed to gift money into custodial accounts on a yearly basis and are able to transfer up to $15,000 under the annual gift exclusion amount. More than this amount can open the sender and receiver up to additional tax issues – so don’t give more than that!
The main reason I opened the custodial accounts for my children was to show them first hand, the power of investing. I wanted to be able to show them how their own money has grown by using sound investment techniques.
This is yet another tool in their finance tool belt to add to their saving, spending, and giving strategies. As I stated earlier, it is our responsibility as parents to teach our children about money – and to give them the necessary tools to be able to succeed in this world. I want to give my kids every opportunity to be successful and to make the most of their hard work and money.
Arrest Your Debt's Pro Tip:
Track your investments for free with Personal Capital. It's how I track my pension and retirement funds.
Don't Forget To Subscribe For My Latest Posts And Giveaways!
Do your children already have custodial accounts? What other money tips and strategies have you employed with your kids? Leave a comment below, I would love to hear from you! Again, if you have not already done so, please add your email below and subscribe to my blog! Thank you for reading and keep up the good work! You work too hard to be this broke!