Investment Accounts for Kids: Options and Considerations

• Parents can teach children about money management at a young age.
• Teach children about budgeting and how to prioritize spending, and reward small successes and milestones.
• A Roth IRA and a 529 plan are two important investment options to help kids plan for two important milestones in their lives: college and retirement.

As a parent, you want to teach your kids the importance of saving and investing their money. It’s never too early to start creating good financial habits. By instilling these habits, not only will you help your child build confidently manage their money, but you can also set them up for a successful financial future. In this article, we'll look at two essential investment accounts for your child and provide you with four tips to encourage kids to save and invest.

Investment Account Definitions

Before diving into the investment options, it’s important to understand a few key definitions:

Compounding: Compounding is a term that financial advisors and money experts often highlight. Compounding is the process of generating earnings on an investment. As the investment grows, it generates a gain, or profit. Over time, these additional earnings, paired with your initial investment, will cause a larger return. 

As an example, if you have $10,000 in a bank savings account with an interest rate of 5%, then after one year, your account will have grown to $10,500. The following year, you would multiply your $10,500 times 5% for a new total of $11,025. Without compounding, year two would be like year one. 

You would multiply 5% times $10,000, for another $500 in interest for a total of $500 in year one, and $500 in year two, or $11,000. Compounding is the process of building wealth based on both the principal and interest rather than just the principal. 

Roth IRA: A Roth IRA is another type of tax-free investment that parents should discuss with their kids. Although retirement can feel very far away as a child, every parent knows that the years fly by sooner than you think. A Roth IRA allows you to invest money in an individual retirement account, also called an IRA, with after-tax dollars. Earnings in the Roth IRA then grow tax-free and can be withdrawn tax-free.
 

529 plan: A 529 plan is an educational savings plan that comes with tax benefits.  The benefits are that the earnings on the accounts are not taxed as long as the 529 expenses are used for qualified education expenses.

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Investment Options for Kids

A Roth IRA and a 529 plan are two investment options that parents may consider for two critical points in their children’s lives: college and retirement. Both investments have their pros and cons, but understanding them and knowing how to mitigate the risks can help parents make an informed decision.

Roth IRA

A Roth IRA allows a parent to help their child plan for the future, keeping in mind that one day, their child will want to retire comfortably.

Pros:

• Both earnings as well as withdrawals can occur tax-free
• Withdrawals can be made at any time without penalties
• There are no required minimum distributions when making withdrawals from your Roth IRA account

Cons:

• There is a limit on how much can be contributed each year; currently, this limit is $6,500 per year for those who are under the age of 50 and $7,500 for those who are 50 or older.
• There is also an income limit for Roth IRA contributions. For children, this income limit hardly matters, but for young adult children, it can come into play. The income limit is $153,000 for single filers and $228,000 for married filers in 2023.

To mitigate the risk of limited contribution amounts, parents can encourage their children to start investing as early as possible and maximize their contributions each year. Parents are also able to open a Roth IRA for their child, once their child starts working, for instance, with their first teenage job.

Recommended Read: The Cost of Raising a Child Has Surpassed $300,000  

529 Plan

A 529 plan is a tax-advantaged savings plan designed specifically for education expenses. The funds may be used for qualified education expenses, such as tuition, fees, books, and room and board.

Pros:

• 529 earnings and withdrawals are tax-free
• There are no income limits for making contributions to a 529 account 
• Some states offer additional tax benefits

Cons:

• The funds can only be used for education expenses. The reason is 529 plans are meant to give parents an incentive, in the form of a tax break, to save for schooling. As such, if you use the money for something other than qualified educational expenses, then you may incur a penalty and be subject to additional taxes.
• Depending on the state, many set limits on the amount that may be contributed annually to the 529 plan. Be sure to check on your state's guidelines before making investments.
• 529 plan's investments are often limited in terms of variety. Most plans only offer mutual funds as investment options, which can limit the potential return on your investment.

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Recommended Read: How To Make Your Child Rich Through a UTMA Account

Encouraging Kids to Save and Invest

Saving and investing are important skills for children to learn at an early age. Below are a few tips on how to encourage the children in your life to save and invest.

1. Lead by example: While children may be told to ‘do as I say,’ children learn by observing the behavior of their parents. Model good financial habits by showing them how you save and invest your money, and the rationale behind those choices.
    
2. Reward savings: Offer incentives for saving, such as matching a portion of what they save or allowing them to spend their savings on something special. An incentive or reward will help instill the importance of saving and make it more fun for them.
    
3. Start small: Start with small investments, such as an online investment mutual fund or stock account, to help children get a feel for how investing works. Encourage them to research and learn more about investment options. If your child has a favorite clothing brand or food, help them learn more about the company as a potential investment option.
    
4. Celebrate successes: As adults, we know how hard it can be to trade away the instant gratification of spending money on shopping or eating out for the longer-term gratification of saving for retirement. So when your child reaches a savings goal, celebrate their success and recognize the hard work and discipline that came with reaching this goal.

Recommended Read: 7 Ways to Teach Your Kids About Money 

The Money Wrap-Up

Parents can lay the foundation for their children’s financial success by teaching them about saving and investing, and helping them establish these habits at an early age. Encouraging kids to save and invest and leading by example will help them understand the importance of good financial habits and set them on the path to financial stability and independence. A Roth IRA and a 529 plan are great options for parents wanting to invest in their child’s future. 

Disclaimer: The information above regarding different investment options for kids should not be considered financial advice. Consult with a professional before making any significant decisions. 

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