Parents often give their children popular gifts — video games, smartphones, drones — that eventually collect dust.
A more beneficial gift is laying the foundation for wealth.
Open a mutual-fund account for your child and set an automatic monthly investment so that by the time he or she is ready to buy a home 20 or 30 years later, the down payment is available. It could even turn out to be a much larger sum of money, depending on how much you can, or are willing, to invest.
To be clear, this is not a college savings fund. It may seem like a radical idea, but this money should not be used to pay for college, cars or rent. This is the start of your child’s nest egg to be used for investment, which hopefully will include a home, and can even seed a lifetime of greater financial freedom decades down the road.
The power of the stock market
John Buckingham, editor of the Prudent Speculator newsletter, argues that millennials and younger people should be 100% invested in stocks because they have such long investment horizons. Stock market returns can vary greatly from year to year, so the longer, the better.
“An understanding of the miracle of compounding would be priceless for young investors.”
The Prudent Speculator is published by AFAM Capital, a division of Kovitz Investment Group of Chicago, and it has achieved a 30-year average annual return for its recommended portfolio of stocks of 12.3% through Sept. 30, according to the Hulbert Financial Digest. That is well ahead of the benchmark S&P 500 index’s 30-year average return of 9.7% (with reinvested dividends), as calculated by FactSet.
Let’s pretend that you have a child who is 10 years old, and you invest $2,500 in an index fund for him or her, along with regular investments of $100 at the beginning of each month. Using the future value formula in Excel, with an assumed annual 10% return for the fund, he or she will have $52,927 in the account after 15 years at age 25. Imagine how much bigger it might be if you can increase that automatic investment as the years go by.
Over that 15-year period, your total investments into the fund would have been $20,500, with your child’s gain totaling $32,427.
“An understanding of the miracle of compounding would be priceless for young investors,” Buckingham said in an interview.
Going much further back, Buckingham said the average annualized return for the S&P 500 from June 30, 1927 through Sept. 30, 2019 has been 10%. It has recovered from every crash.
Indexing and automatic investments
You may already be familiar with index funds, which are mutual funds that are designed to track the performance of stock indexes. An S&P 500 Index SPX, +0.31% fund is meant to match the performance of that benchmark while also charging a much lower annual management fee than a traditional actively managed fund would.
One example (of many) is the Fidelity 500 Index Fund FXAIX, -0.20% , which is designed to mirror the performance of the entire U.S. stock market by investing at least 80% of its assets in the S&P 500. It has remarkably low annual expenses of 0.015% of assets.
Control, taxes and other considerations
When you set up a bank account or mutual fund account for your child’s name, it is usually done under the Uniform Gift to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA). Each state has its own age of majority, at which the child can take control over the money if he or she wishes. This can be age 18 or 21.
And those ages seem younger as we get older, don’t they? This underlines the importance of providing your child with a real financial education. What do things cost? What did you have to sacrifice to get where you are now?
Your child should understand the purpose of the gift. Watching the account grow over the years (and shrink during periods of stock-market decline) will help him or her understand what it means to participate in the U.S. economy and build financial assets. Hopefully, your child’s understanding will help them make prudent decisions when they grow up.
If you decide to make this gift and stick with it, the account may become very large over time. There will be other things to consider, including how the account will affect the child’s eligibility for financial aid if he or she wishes to go to college. Applications for financial aid are complicated. The primary factor in determining eligibility is income — the ability of the family to afford college tuition. But assets are also taken into consideration.
You will also need to think about when you want your child to have complete control over the account. If you wish to maintain control over this money after your child becomes an adult, speak to a lawyer about having a trust drawn up.
There may also be tax implications: If you give large financial gifts to your child — much larger than the one in our example above — the ultimate size of the gift (the amount you invest for them) may affect the tax consequences of your estate plan. Depending on the rules in your state, the total amount of financial gifts to your child may be very important in determining the eventual taxes on your estate.
So with implications for financial aid, control of assets and taxes, it’s a good idea to discuss the implications of this type of investment with an accountant and a lawyer.
An investing adventure
You can share a stock-market adventure with your child, teaching him or her prudence and discipline. The stock market doesn’t rise in a straight line — there can be big declines every few years. But with regular monthly investments, your child will be paying lower prices to buy shares when the market falls, enhancing the return as the market rebounds. You and your child will be able to watch this cycle repeat as the account grows. A stock market plunge can then be seen as an opportunity, rather than something to be feared. This will help him or her gain confidence and the patience required to be a successful long-term investor.
So this really is a gift that lasts decades.
“It is the gift of knowledge — more valuable than money,” Buckingham said.