Saving for Your Kids Can Be a Lifelong Lesson in Financial Literacy

Have you read the book series written by Laura Numeroff, If You Give a Mouse a Cookie? The story progresses through the incremental effects of the decision to give a mouse a cookie.

We have our own take on this story; it’s called, “If You Give a Child Savings.” Our version goes like this:

If you give a child savings, they will see the importance of preparing for the future. And if they see the importance of preparing for the future, they will want to save too. And if they start to save, they will learn the concept of compounding growth. And if they learn the concept of compounding growth, they will want to maximize their earning potential. And if they want to maximize their earnings potential, they may seek investments. All because you gave a child savings. The End.

So how do you get this ball rolling? Start early

You can start saving for a child at any point in time, but earlier is always better. The simple reason is the impact of compounding. Because the longer an investment has to grow, the larger it may become. For example, let’s take a diversified market portfolio that grows at 7% per year on average. Investing $5,000 when your child is 15 years old grows to only $7,095 when they are age 20. Pretty good, but not great.

But if it is invested earlier, when they’re 10, or five—or even better, only a few months old—it will grow vastly larger.

However, you may not have a lump sum of money available to sock away for them. Instead, you’re able to periodically save a smaller amount. How could that grow over time? Similarly, a contribution of $1,000 every year can possibly grow to a jaw-dropping sum over a longer period if it grows at 7% on average per year.

Ok, you see the benefits of investing early and/or often. Next question: Should you add these funds to your investment account? The answer is probably not. Rather, you may want to consider an account specifically geared toward minors.

4 types of accounts for minors

529 Qualified Tuition Plan

When the goal is to help pay for future education, a 529 account is often an advantageous choice. For example, contributions are made with after-tax money. The invested money grows tax-deferred and can be withdrawn tax-free if used for education. (If you are familiar with a Roth IRA, this works in a similar fashion. Read below for more information.) The tax benefits from a 529 can save you thousands of dollars in taxes versus other investment accounts.

Every state offers a 529 plan, and if you use the plan offered by your state, you may also get a state tax deduction. For example, if your particular state has a 5% state income tax, and you invest a total of $20,000 over time in that state’s 529, you may save $1000 in state income taxes. Just remember, to get tax-free growth, the withdrawals must be spent on education. If it isn’t, you’ll pay the tax and an additional 10% penalty as well.¹

Custodial account

What if you want to save for something other than education? If you’re not sure if the money will be used for education, you might want to consider a custodial account, such as a Uniform Transfers to Minors Act account (UTMA) or a Uniform Gift to Minors Act account (UGMA). A parent or an appointed third party (the custodian) manages these accounts when the child is a minor (the beneficiary). The child takes control when he/she becomes an adult, by age 18 or 21, depending on the state. It’s important to note that once the money is contributed, it belongs to the beneficiary, and the beneficiary cannot be changed.

The tax benefits for UGMAs and UTMAs, although not quite as good as 529s, are still advantageous:¹

• Up to $1,250 in earnings tax-free.
• The next $1,250 is taxable at the child's tax rate.
• Any earnings over $2,500 are taxed at the parent's rate.

Donors also get a tax benefit. While contributions are made using after-tax dollars, gifts are tax-free up to $17,000 per person for 2023.²

Trust

A trust account is a way to ensure that money you intend for certain people, such as children, is safeguarded and cannot be diverted under adverse situations, such as if you die, go bankrupt, lose a civil lawsuit, or suffer business failure. For example, when you die, your will can be legally challenged, or your widow(er) who inherits the money can have different ideas for who to leave it to. Or if you lose a civil lawsuit, your assets can be taken from you. But money set aside in a trust is safeguarded against any legal or other challenges.

A trust also lets you specify, if you choose, a year (or age) when the money will be released and even allows you to prescribe how the money must be spent. To do this, the trust must be an irrevocable trust, which means its specifications cannot be changed after it is created, even by you. If you want to be able to change its specifications later, then open a revocable trust. But for these, the money is not protected from legal challenges.³

Roth IRA

Roth IRAs are another type of account that may make sense for some minors. The caveat with this account is that it is only available to minors who earn an annual income. But the benefits can be tremendous.

A Roth works like this: You (or your child) can contribute up to $6,500 (or an amount equal to your child’s annual income if less than $6,500) of after-tax money into a Roth account. And because your minor probably has a very low tax rate, the tax consequences of after-tax contributions are likely minimal.

Now the benefit: The earnings growth on those contributions is tax-free, forever! So when they withdraw their money in retirement, your child will not pay any taxes. Ever.

But the IRS has some rules on when money can be withdrawn. Contributions can be taken out at any time, but earnings cannot be removed without penalty or taxes until your child reaches age 59½.³

A secondary, but equally important, benefit of saving for your kids: Financial literacy

Like in our version of the mouse and cookie story, we believe that teaching your kids about finances at an early age is critical. So why not use this opportunity to start learning? Children:

Between the ages of 3 and 5, for example, are observing money transactions taking place in their family and can understand the concepts of spending, saving, and giving money. Tell stories about these concepts or use an activity to get them involved.

Suggested activity: When your kids find loose change around the house, have them split it equally among two jars—one for saving and one for spending. Once they reach a savings goal, they can use the spending money to buy a reward.

Between ages 6 and 12, these money behaviors can become more deeply ingrained. You can also start the concepts of earning and investing. Many parents introduce simple chores like making the bed, or setting the table, as an expected part of a child’s routine and “pay” them (if the chores are done) with a weekly allowance. This is also the period when some parents take their kids to the bank to open a savings account, so they can deposit their allowance and see it grow over time. When a child expresses a desire to buy something, a parent can help them save for and buy it with their allowance to drive home the concepts of earning, saving, and growing their money.

Suggested activities: To maintain your child’s interest in the account, try connecting it to something they look forward to. If the child dreams of becoming an astronaut, call it their “astronaut” fund and discuss how it can help pay for their education. If they dream of being a doctor, call it their “doctor” fund. On a quarterly or annual basis, you might ask the child to read the balance of their astronaut fund and compare it to the initial investment, then discuss the change and progress to their goal.

More regularly, you might also use the child’s interests to stir discussion about how to choose investments. If the child likes science, you might discuss which biotech companies are doing well and maybe buy some stock in one. Discuss what the company does and ask the child if they think it will get more customers over time. If they like medicine, you might invest in a healthcare company, discuss its products, and whether it has a good direction.

Some of the important basic but timeless concepts to introduce include the power of compounding, diversification, buy and hold, and dollar-cost averaging. It’s good for them to know such phrases as “Time in the market is better than timing the market.”

How important is financial literacy?

Unfortunately, financial literacy is not strong in America. But studies show that when people receive financial education, they make better choices. Students are more likely to apply for aid and borrow at lower rates, which makes them more likely to finish school. Adults with more knowledge about finance (from a class, a financial coach, a company plan, or an advisor) start saving earlier for retirement and are less likely to sell investments during a downturn. Financial education also reduces the likelihood of holding high-interest credit card debt.

Currently, less than half of the states require high school students to take a personal finance course, and only half require an economics course.⁵ This makes it all the more important for parents to instill good financial skills in their kids at home. So as you start saving for your kids (or grandkids), think about how you can stimulate good financial habits at an early age and start a healthy lifelong relationship with money. Your kids will thank you for it!