The Best (And Worst) Investments You Can Make For Your Child

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 you this story because your child's future may be a roller-coaster ride, too. We can't control it. 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:

General Education and Wellness

There is nothing more important than investing in yourself. Teach this to your children as soon as you can. 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. Take a look at the shocking difference these growth rates can make over the long term:

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

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

The growth of your paycheck is more meaningful than the growth of your investments in the first half of your life. It's important for your children to get the best job they can and work hard in those early years. You're a role model, so set a good example.

Take care of yourselves - Your family's health and wellbeing (including your own) 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 your child's future: How can our children succeed if they are taking care of sick parents?

Read to your child from the start - Your child is more likely to go farther in school if your 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.

Learn together - "What is money? Really." The world's smartest economists have a hard time answering that question. Meanwhile, most parents confidently answer: "Pfft, it's that 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.

Teach wants vs. needs - "I don't want to go to school. I need a fidget spinner." Our 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. 

Ask thoughtful questions - "Would you rather have one million dollars now or the sum of a penny, doubled each day, for 30 days?" (The doubling penny adds up to 10.7 million dollars by the 31st day of the month.) "If everyone in the world magically had twice as much money, would everyone be able to buy twice as much stuff? Would the price of that stuff go up or down?" I've asked young kids questions like these, and with a little bit of thought, they usually answer correctly. Meanwhile, I've met smart adults who seem incapable of understanding financial concepts like compound interest and inflation. I can't explain why this happens, but I'm convinced that children need to solve financial riddles themselves (before they learn incorrect or incomplete information later in life).

529 Plan or Coverdell Savings Account

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

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

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

The earlier you start investing, the better chance you have to be successful at it. This is especially true when you're 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 if you act 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. 

You don't need to be a genius to invest in the stock market. A high-school education is more than enough. 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 you 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 as long as you invest through the ups and downs of the stock market, you'll 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 you sell your home to a stranger for pennies on the dollar because he told you that you paid too much to live there? Of course not. Don't sell your investments so recklessly either. As we saw in the example above, things can work out OK even if you buy into the market at a bad time.

 

Let's get back to 529 Plans and Coverdell Education Savings Accounts. These are two popular ways to save for college in a tax-advantaged way. Both plans have their pros and cons, which I've summarized in the table 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 you may need soon, but you 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's what you need to know:

1. You don't need a financial adviser to open a 529 account - Great plans are available to you directly and you can save a lot of money by opening your own account. 

2. You can invest in any state's 529 plan (and you should explore your options) - Morningstar groups 529 plans from best to worst. I hope your state has a great plan, but look elsewhere if it doesn't. A small tax break (which some states offer for investing locally) does not excuse poor investment options or ridiculous fees.

3. Never, ever, pay a sales charge or load - Paying for the right to invest in a fund is as ridiculous as paying an employer to offer you a job. You'll want to find a plan that offers 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.  

 

Savings Bonds

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. If you buy a $100 EE bond for a newborn child, that same bond 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 you're 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. You can avoid federal tax too if the redeemed bonds are used for qualified educational expenses (and if you meet certain requirements). Bonds that are registered in your 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.

Bank Account

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. I know parents who still teach their children that putting money in the bank is how to grow rich. That's not true.

Banks protect our money, insure it and help us access it from anywhere in the world. They are the keystone to modern life.

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

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) your child along with banking concepts like ATM fees, direct deposit, wire transfers, etc.

 

How to Talk 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).

Watch The Big Short together as a family if your kids are older and you can stomach the film's R-rating. That movie gets a surprising amount of details correct (it's based on a great book) and it tells what could have been a long, boring story in a short, entertaining way.

Young kids don't need to know the dirty details of the financial crisis. They just need basic guidance about money and life. Love people, use things (not the other way around). Don't fool yourself into needing the things that you want. Admit your mistakes early because you might not be able to solve them later. The better our kids understand lessons like these, the less likely they are to make a big financial mistake or take guidance from someone who wants to rip them off.

 

Roth IRA

A Roth IRA can be opened at no cost and companies like Fidelity and Scottrade don't charge maintenance fees for having an account. Your child might not be able to open a Roth IRA without you, so be sure to make yourself available.

It's going to be a tough sell to convince your teenage child to save for retirement, but it may be the most important financial discussion you ever have. Find a compound interest calculator and plug in some numbers (the U.S. stock market has returned about 10% per year, before taxes and inflation, since the 1920s). Discover together how invested money can magically grow over time. Here's the amazing thing about investing in a Roth IRA: You 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). Help your child contribute the maximum amount if you're able. 

Keep records of your child's earnings and file a tax return if you must. A Roth IRA lets your earnings grow tax free because the money you put into the account was already taxed. Most teenagers though will pay little to no income tax to begin with. A double win! 

Investment 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 your high-schooler's investing experience is the thing that gets him or her into a top-rated university. You can't predict things like that. Be mindful together, though, about paying taxes on your gains or offsetting your losses.

Cash

Cash is not an investment, but it is like insurance: It's great to have when you need it. 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

You can impact the money supply and inflation (albeit, in a very small way). Let's pretend that you lend a friend a few hundred bucks. What if you and your friend unknowingly bid for the same item on eBay? You're going to drive the price of that item up; other sellers may increase prices and buyers may increase what they are willing to spend.

What if your friend stiffs you? Poof! That money has "disappeared" and you might change your actions because of it (like not buying something else that you would have).

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 your pocket over time unless your investments are growing faster than the inflation rate. The government-reported inflation rate is about 2% over the long term. At that rate, your money will lose half its value in 35 years. I figure the inflation rate is closer to 4.5%, a rate that will cut your purchasing power in half every 15 years. Only you know how fast your expenses are growing, so invest accordingly.

Final Thoughts

I haven't written about trusts, pre-paid tuition, or the particular challenges that divorced or same-sex parents must endure. I suggest that you speak with a legal or financial professional if you have questions about those things. 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.

I hope that you learned a few things while reading this article (I certainly did while researching it). May your family be blessed with good health and good fortune. Happy investing!