Make your kid a millionaire
You may not have the cash right now, but you've got plenty of time if taxes, fees, mistakes -- or the child -- don't steal your thunder.
By Liz Pulliam Weston
Call it the ultimate Christmas gift for your child or grandchild: a cool $1 million.
It's a lavish gift, but not a prohibitively expensive one. A monthly contribution smaller than your current cable TV bill, made faithfully until the child turns 18, will hit seven figures without outlandish investment choices.
A newborn has nothing but time -- and that's something this strategy exploits to the fullest. Let's say a 30-year-old manages to save up and then invest a lump sum of $10,000. At an annual return of 8%, by the time she's 65, that $10,000 will have grown to nearly $150,000. Not bad, right?
But then compare it to what a 5-year-old could make from the same $10,000. The extra 25 years of growth would give him over $1 million by age 65. A newborn would need just $6,700, less than the cost of a decent used car.
If you don't happen to have $10,000 handy, not to worry. You can get the same results with a monthly investment, made even smaller if you can persuade your child to keep the contributions up over the long haul.
Take a look at what's possible in the table below. All the examples presume 8% average annual growth, a reasonable return from a diversified mix of stocks, bonds and cash, according to respected financial research company Ibbotson Associates.
To accumulate $1 million by age 65:
Starting at: One-time contribution Monthly contribution until age 18 Monthly contribution until age 65
Birth $6,721 $56 $38
Age 5 $9,875 $98 $57
Age 10 $14,511 $200 $85
Age 15 $21,321 $662 $127
Pretty neat, huh? I've heard from quite a few parents excited about the possibilities. Many believe their own financial futures were stunted by not investing early enough, and want their children to avoid the same mistake.
But there's a downside. While time can help the young grow a fortune, it can also magnify any investing mistakes made along the way. If that 5-year-old's account is traded excessively, charged high fees or invested too conservatively, the nest egg may be dramatically smaller.
If our youngster eked out only a 6% annual return over time, for example, his account would be worth just $330,000 at retirement age.
Furthermore, your kid's wealth accumulation plan could cause havoc with future financial-aid packages, so you'll want to know how to minimize the impact.
Who's a good candidate?
As nifty as the math is, you shouldn't start building your children's fortune until your own financial path is secure. That means all of the following are true:
* You're on track saving for your own retirement. No matter how much you want to secure your child's financial future, you must attend to your own first. (Your kid won't thank you for your largesse if she winds up using it to support you in your dotage.) You can use MSN's Retirement Planning Calculator to check. If you're a grandparent and already retired, you should be confident you have more than enough money to get you through the rest of your life. T. Rowe Price's Retirement Income Calculator can help you decide.
* You have no consumer debt. Again, you want to be on sound financial footing yourself before helping your kids, and that means paying off the credit card balances, unsecured personal loans and any other high-rate debt. (If you've got low rates on your auto loans or student loans, though, you don't necessarily have to pay those off before you invest for your kids.)
Video on MSN Money: Open an IRA for your child
family finances © Corbis
Why not? If the kid has earned income, sock the money in a Roth and the child's on the road to wealth. Click here to play the video.
* You're saving for college. That future $1 million won't mean much if your kid doesn't get a good education or winds up saddled with massive student loan debt.
* You're willing to spend some time educating your children about money. For the million-dollar plan to succeed, your children have to understand the importance of keeping their mitts off the money so it can grow. They need to know that every $1,000 they withdraw at age 21 will cost them nearly $30,000 in future retirement money -- plus any taxes and penalties that may be owed for tapping the money early.
If you've got your financial bases covered, then you can proceed.
What about taxes?
Lots of expensive financial products are sold to people who panic unnecessarily about the effects of taxes on their investments. While it's true that taxes over time can reduce your investment returns, they're easy enough to minimize without paying a small fortune in fees to stockbrokers or insurance companies.
What tends to generate big tax bills is excessive trading, either by professional mutual fund managers who take a so-called "active" approach to investing or by the parent or grandparent managing the account.
There are better ways. One possibility is index funds, which mimic some broad-based market benchmark. Index funds change their lineup of investments only when the underlying benchmark changes, which isn't often.
Another bonus: Index funds are cheap, which means you're saving on fees. Instead of paying 1.4% a year, which is the average expense ratio for actively traded mutual funds, you pay:
* 0.54% for Charles Schwab's Total Stock Market (SWTIX).
* 0.4% for T. Rowe Price's Total Equity Market Index (POMIX).
* 0.19% for Vanguard's Total Stock Market Index (VTSMX).
Also, with a broad-based stock market fund, you're pretty much guaranteed to do at least as well as the overall stock market. Compare that to the two-thirds or so of actively managed funds that fail to beat their indexes over time, and you'll see that index funds are a pretty good choice.
A big drawback: These funds, like most mutual funds, have pretty hefty minimum investment requirements that can be problematic for folks investing small amounts. Schwab and T. Rowe's funds require a $2,500 minimum purchase; Vanguard wants $3,000, although all three knock their minimums down to $1,000 for custodial and retirement accounts (see below). Schwab lets you make subsequent investments of any amount, while T. Rowe's ongoing minimum is $50 and Vanguard's is $500.
Additional account fees may be charged if your balances are below certain amounts.
Other options: buying and holding individual stocks or exchange-traded funds (ETFs). ETFs, like index funds, are bundles of investments meant to mimic a benchmark, but unlike funds -- which are traded once a day -- ETFs trade like stocks throughout the day.
Buying ETFs and stocks through a brokerage can get pretty expensive, though; trading fees will eat up a good chunk of your monthly investment. A cheaper alternative: ShareBuilder.com, which charges $4 a trade and has no investment minimums.
Yet another possibility: buying shares directly from the companies, avoiding commissions. Minimum purchase requirements and fees, though, vary widely by company. DirectInvesting.com can help you get started.
What bucket to use
Here's an issue that actually is important: minors generally aren't allowed to hold investments in their own names. But each alternative has its cons as well as its pros. For example:
A custodial account. These accounts, usually known as Uniform Transfers to Minors Act (UTMA) or Uniform Gifts to Minors Act (UGMA) accounts, are getting less popular as their disadvantages mount. For one thing, you'll get slaughtered at college time, since financial aid formulas consider this the student's asset and penalize you heavily for it. Also, the kiddie tax rules have changed so that if the account earns more than a certain amount annually ($1,700 in 2006), taxes are paid at the parent's rate, rather than the child's, regardless of the child's age.
A joint savings account. These are pretty easy to set up, but may have tax issues. The same kiddie tax rules apply: If the account earns your kid more than a certain amount ($1,700 in 2006), taxes must be paid at your rate. Also, the account is considered jointly owned for college financial aid purposes, so half of it (your kid's half) will count heavily against you.
Holding the assets in your own account. This will benefit you in financial aid calculations, since colleges expect you to contribute a smaller percentage of your own assets than of your children's to pay for college. (If you're a grandparent, your assets aren't counted at all.) But you'll pay taxes at your higher rate and (if you're wealthy) you could create gift-tax issues for yourself when you finally transfer the money to your kid. By "wealthy," I mean you plan to give away more than $1 million to individuals over your lifetime. If you're in that bracket, definitely talk to your estate-planning attorney first before starting any funds for your kids.
Roth IRAs. These are great: Contributions and earnings are entirely tax free in retirement, and Roths, like other retirement funds, aren't counted in financial aid calculations. But kids can have a Roth only if they have earned income at least equal to the amount they (or you) want to contribute. (The maximum contribution these days is $4,000 annually.) Earned income means wages; allowances and gifts from relatives don't count.
Variable annuities. Anyone who's read my columns for awhile knows that I'm not a big fan of variable annuities for most investors (and that's putting it mildly). Most VAs are overpriced, oversold and just generally a bad idea. But they do have some advantages when used for kids. There's no contribution limit or earned income requirement, as with Roths, and they aren't counted in financial aid calculations. Big downsides: Your kids will get clobbered by taxes when they withdraw the money in retirement, since earnings are taxed as income, and withdrawals before retirement are penalized. (If you held the investments directly, outside a variable annuity, you'd qualify for the low capital gains tax rates.) If you are considering an annuity, go for a cheap one, like the ones offered by Vanguard.
Life insurance. Bleah. Kids don't need life insurance, and your money will go a lot farther if you're not paying for insurance you don't need, plus commissions and an insurance company's overhead.
Making sure they don't blow it
What if you're worried about your child raiding the money prematurely? Your control is limited with all but one of these options: holding the investments in your own name. Otherwise, at some point -- certainly by age 25, if not before -- your kid will have access.
If that unnerves you, you can either opt to keep the funds in your own account or spend a substantial wad on elaborate trusts designed to dole the money out over time.
But bear in mind that your children's future fortune will be worth less than $27,000 at age 18. The real growth will come over the following decades. While prematurely raiding their cache might prevent them from achieving the million-dollar kitty you want them to have, it's not like they'd be able to spend seven figures on a car or decorating their dorm rooms.You can warn them about the folly. You can encourage them to see the light. You could even threaten to cut them off financially.
But in this, as in so many other areas of parenting, you may just need to keep your fingers crossed -- and let your kids make their own mistakes.
Liz Pulliam Weston's column appears every Monday and Thursday, exclusively on MSN Money. She also answers reader questions in the Your Money message board.
http://articles.moneycentral.msn.com/CollegeAndFamily/Advice/MakeYourKidAMillionaire.aspx
Accueil 
