“I have some money that I would like to invest for my child. How should I invest it?”
This is one of the most popular questions I hear.
The good news is that I get it.
One of my biggest drivers for investing is making my children financially independent long before they are adults.
I want to help my boys create a future where they can do whatever they want in life without worrying about money.
My 8-year-old is passionate about dinosaurs, and the 5-year-old is obsessed with space.
I know… this can change a lot of times before they grow up. But should they wish to dig for bones or study the stars, I want to make sure they can follow those passions.
I also hope they’ll never have to worry about being able to afford retirement. I’m taking care of that for them.
Is it realistic?
Of course it is. But it depends a lot on how much money you invest for them and how good you are at getting a stable return year after year.
You can help them get a good start in life for a lot less money than it will cost them in the future.
I’ll give you some examples.
If you invest $10,000 and receive an average return of 15% a year, it could theoretically become $38 million by the time your child turns 60.
For small children, you have about 20 years before they need to spend money on education abroad or housing.
Theoretically, you can invest $100,000 and turn it into $1.6 million in twenty years, if you get an average return of 15%… and don’t have to pay taxes.
You probably have two objections to this.
First of all, you could argue that 15% is unrealistic, but nonetheless it’s the goal that I myself set for my kids’ investments.
Secondly, taxes are a fact of life, and when you calculate how much the money will turn into, you’ll get a different result if you factor in taxes.
But wait. You have to read on. There are solutions.
This is where you have to be smart about how you invest for your kids. You have to use the tax-efficient ways of investing that are available to you.
The point I’m trying to illustrate with the two examples is the magic of investing for children: there is plenty of time, and compounding can work wonders.
1. Use Tax Efficient Savings Accounts for Children
Almost all countries have some kind of vehicle that allows you to invest for your child without paying taxes on the returns.
In the UK, it’s called a Child Trust Fund or ISA for children.
In the US, you can create education savings accounts such as Coverdell ESAs or 529 plans.
I’m not going to go into too much detail about how much you can contribute or what the specific rules are because it varies from country to country and sometimes from state to state.
The point here is you have to find out how you can invest for your child tax-free, because there will be a way. Most countries have a version of a tax-free account for children.
Rules you should follow when setting it up
Start as early as possible so compounding has time to work.
Set the child trust funds to run as long as possible so compounding can work its wonders while you also avoid it getting paid out while they are teenagers.
2. Use Tax-Efficient Retirement Accounts
Don’t stop at saving for their education.
Set up a retirement account for your child as well (in the US you can set up a Roth IRA for you child and in the UK you can set up an ISA).
Why would you set up a retirement account for your child?
Why wouldn’t you? For very little money, you can secure their retirement because of the wonder of compounding.
Do it as early as possible so compounding can make even a little investment into a lot of money.
3. Invest For The Long Term
There is another way to make your children’s investment more tax-efficient, and that is by investing for the really long term.
Outside the tax-efficient accounts such as the US’s Roth IRAs and the UK’s ISA, you pay taxes on capital gains.
But you only pay taxes when you sell stocks.
So what about investing in companies that you feel sure will still be a good business in 20 or even 60 years?
There are two benefits to investing this way.
Firstly, you avoid paying taxes for all that time if you keep the stock and don’t sell it. Compounding, compounding, compounding.
Secondly, you avoid the worst kind of daredevilish mistakes that many people make.
People make investing mistakes when they think they have found something that will explode in value in the near future. It’s usually too good to be true.
You make better investing decisions when you think very long term.
Overall, there are two ways you can invest. You can pick stocks yourself, or you can invest in an exchange traded fund (ETF).
I am a big proponent of the investing style called value investing. This is a method where you select individual companies whose stock prices have fallen to a level where they are on sale. You can read a lot more about how to do it in my e-book here.
However, choosing individual companies requires some work. You should look at the numbers, go through a checklist, and calculate how much the company is really worth.
If you already know that this would be too much work for you, the passive investing style is your best bet.
Here are the most important investing principles to follow when investing in ETFs:
- Choose an ETF that follows a stock index (like Dow Jones or S&P 500)
- Choose an ETF that is cheap in annual costs (should be less than 0.20%)
- You can look this up on sites like morningstar.com
Learn More About Investing
If you invest in ETFs, you can’t expect the rate of return to be higher than 8% on average a year.
This means that the $10,000 you invest in your child’s retirement account will become less than a million as opposed to 38 million.
If you want to make yourself and your children financially independent, there is no way around it: you must become a good stock picker.
You must learn to follow a checklist, ask some critical questions, and think long-term.
It’s money well spent to invest in courses or a coach who can help you become a better investor.
A good place to begin is with my e-book right here. Make sure you’re on the email list so you can be invited to the free webinar I will be hosting soon.