Gifts That Pay Off: Gifts that pay off: Turn your child into an early (and savvy) investor
This is the third story in a new MarketWatch series, “Gifts that pay off.” Every Monday, Wednesday and Friday between now and Dec. 25, we will look at gifts that could potentially earn the receiver money.
The most difficult part of giving presents around the holidays, at least for me, is coming up with good ideas. But now I have one that your child can appreciate for decades — a practical gift that can lower their stress and set up a healthy financial life when they reach adulthood.
I used to dread this time of year. Not only because I would refuse to wear the sweaters I was given, but because it kept getting more difficult to come up with ideas for presents for people who lacked nothing. How many times can one score by coming up with something rare or unexpected that the recipient would love or, at least, be amused by?
So in my extended family we all agreed to stop giving presents, except for children.
Then I realized that once a child in our electronically connected age reaches the age of 11 or 12, or thereabouts, he or she no longer has much interest in traditional toys or games, and there are limits to how many games they want for their X-Boxes, etc. There are also limits on how many electronic devices you can buy for them.
Don’t miss: Why I won’t spend one red cent on gifts for family and friends this Christmas
There’s also a need for parents to explain financial matters to children. How much do things cost? What did you have to sacrifice as a young adult to afford a home or otherwise get where you are now? What does it mean to save and invest money? You can tackle these subjects with your child, while giving him or her a lasting gift that may even kindle their imagination.
My gift idea?
My gift idea? 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 take the plunge and buy a home, the down payment money is available.
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 take the plunge and buy a home, the down payment money is available. It could even turn out to be a much larger sum of money, depending on how much you can invest, or are willing to invest.
Yes, this is about giving your child the power to buy a home when he or she is ready. This may seem to be a radical idea, but this money should not be used to pay for college or for cars or for rent. This is the start of your child’s nest egg, to be used for investment, which hopefully will include a home.
The power of the stock market
Last April, I interviewed John Buckingham, editor of the Prudent Speculator newsletter, which had a No. 1 ranking for performance since inception 40 years earlier from the Hulbert Financial Digest. Buckingham made a strong case that millennials should be 100% invested in stocks, because the stock market as a whole tends to outperform other asset classes by very wide margins over long periods. From June 30, 1927 through 2016, the S&P 500 Index SPX, -0.08% had an average annual total return of 9.9%.
Millennials of course, have a multi-decade investing horizon, making that sort of allocation quite reasonable. So do children.
Over the past 25 years, the S&P 500 has had an average annual total return of 9.7%, according to FactSet, so the long-term average has held up, despite financial crises and bear markets.
Let’s pretend that you have a child who is 11 years of age, and you invest $ 2,500 for him or her in an index fund, along with regular investments of $ 100 a month (starting the first month). Using the future value formula in Excel, with an assumed annual 10% return for the fund, after 168 months (or 14 years), when your child is 25, he or she will have $ 46,460.28 in the account. Imagine how much bigger it might be if you can increase that automatic investment over the years.
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 indices. An S&P 500 index 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 charge.
The idea of an index fund is not only to hold down costs, but to participate in the entire market. This approach might be less risky than a portfolio of a few dozen stocks selected by a professional, and it may perform better over time. If the index fund beats the long-term performance of an actively managed fund, it may be entirely because of the index fund’s lower expenses, as Berkshire Hathaway Inc. BRK.B, -0.34% CEO Warren Buffett explained in his annual letter to shareholders in February. (Buffet’s explanation begins on page 21, but you should read the entire letter. It is not only informative and educational, it is entertaining.)
As I explained in this recent article about investing in 401(k) and similar retirement accounts, an important advantage of making regular investments is that when the market goes through a period of decline, you are paying lower prices, which improves your return when the market recovers.
Here are some examples…
Many of the largest mutual fund companies offer accounts directly to investors, with relatively low minimum investments and automatic investing plans with low minimums.
For example, Vanguard Mutual Funds has a $ 3,000 account minimum, and no minimum for automatic monthly investments. If you do not want to start with $ 3,000, you can begin with a zero balance and set up the automatic monthly investment for any amount. The money will be invested in a money market fund until you reach $ 3,000 and move it into an index fund or other type of stock fund. The Vanguard 500 Index Fund VFINX, -0.07% is designed to match the performance of the S&P 500 by holding all 500 stock in the same proportion as the index. The management fee for the fund’s investor shares is 0.12%. (An actively managed fund can easily have annual expenses of 1.00% or more.) There is also a $ 20 annual service fee for accounts with balances below $ 10,000. However, this fee is waived if you elect to receive electronic statements rather than statements sent in the mail.
Fidelity Mutual Funds has a $ 2,500 account minimum, and a $ 10 minimum for automatic monthly investments. You can start an account from zero if you wish, with the money invested in a money market fund until you reach the $ 2,500 minimum. Fidelity’s 500 Index Fund FUSEX, -0.07% has an annual ratio of 0.09%, and is designed to match the total return of common stocks publicly trade in the U.S., with at least 80% of assets invested in S&P 500 stocks.
Indexing is very popular and there are plenty of other fund families and index funds to choose from. You may also wish to go with an actively managed fund, depending on what type of strategy or what level of risk you are willing to take with your child’s money. For such a long-term investment, a broad focus may be best, and you might want to discuss the matter with your broker, if you have one, or an investment adviser.
Control and taxes
When you set up a bank account or mutual fund account for your child, in his or her 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. For example, a child may finish college with debt they never expected if their parents never discuss the cost with them.
You 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.
But 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.
One more thing to consider: 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.
Monday: Gifts that will encourage you to rise up the ranks in your career