Paying dividends for a lifetime

Investing for Children

by Gary Foreman


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We have four grandchildren that we have been purchasing stock for at Christmas for the last 10 years. The stocks are valued from $500 to $3,000. The brokerage house fees were running too high even though we had them under our account. We have just liquidated the accounts and our goal is to look for the best place to invest this money and continue our yearly $150 contribution for each.
Rich

Rich is right. Investment expenses matter. The Securities and Exchange Commission calculates that a 1% difference in expenses on a $10,000 investment earning 10% annually would mean a difference of $11,133 in 20 years. Rich isn't investing that much, but clearly the difference is dramatic.

And Rich is also right that beginning a savings program for children is a great idea. For instance, a public college that costs $24,610 per year today (source: CollegeData.com) would cost over $70k in 18 years if costs rise 6% per year.

There are two things for Rich to consider. First, how will he invest? And, second, how will the investment be legally owned?

Owning individual stocks is very hard unless you're going to be investing more than $150 at a time. Even a minimal $8 commission reduces your $150 investment by more than 5%. So it takes 6 months or so to earn enough to make up for the commission paid.

Generally, mutual funds offer more flexibility for the small investor. The average expense for a mutual fund that invests in domestic stocks is 0.68% per year (source: Investment Company Institute). That's a whole lot better than the cost of buying individual stocks.

Owning a mutual fund allows you to reinvest dividends, which is something that's almost impossible with an individual stock unless a DRIP (dividend reinvestment plan) is available. If a DRIP is available for your stocks in this situation, it would be wise to use it.

Rich will want to consider something called an "index" fund. Those are funds where management does not try to pick stocks that will beat the market. The fund is managed so that it reflects the make up of an index. For instance, an S&P 500 fund would have shares in the same proportion that they were in the S&P 500 index. Shares would be bought and sold to maintain that proportion.

There are two main attractions to index funds. One is that their expenses can be lower. For instance, the Vanguard S&P 500 fund has an expense ratio of about 0.18%. But check the expenses on any fund. Some index funds have much higher expense ratios.

The index funds also generally perform better than the average managed mutual fund. As it turns out, most managers don't earn more than they charge the fund. And that means that the average fund does not perform as well as the market.

If you are going to consider a managed fund, look for one that has a good 10 year track record. A great one or five year track record could have been caused by some unique factors that had nothing to do with the fund's managers. And, that could actually work against the fund once you've bought it.

And make sure that the manager who earned that track record is still with the fund. Managers do retire and change jobs. You don't want to invest in a fund that's done well the day after the fund manager resigns!

How should the investment be owned? Ideally, Rich would set up a UGMA (uniform gifts to minors account) for each child. He (or any legal adult) could act as custodian until the child became an adult.

Because legally the child owns the money, Rich would not be liable for any taxes on dividends or capital gains. The one disadvantage is that the child can use the money however they choose when they reach the age of adulthood.

Using an UGMA account has another advantage. As they become old enough to understand, you can review the quarterly statements with them. It's a perfect opportunity to teach them the basic facts about money.

If Rich is afraid that their grandchild will spend the money foolishly when they reach 18 (do I hear a new sports car in the driveway?), they can set up an irrevocable trust for them. There are some expenses to setting up a trust, but that would allow Rich or someone he chooses to be the trustee. The trust provisions and the trustee can have some control on how the trust monies are spent.

There's another, non-financial benefit of talking to your kids about their investment account. Often children strive to achieve our expectations for them. Knowing that you're saving for their college could encourage them to strive for the grades that they'll need.

calculator iconCalculator: What It Takes To Save For College

Rich might also encourage his grandchildren to add to the fund themselves. Kids often receive cash gifts. If they take just a small portion of each gift and add it to their investment account, they'll take a keener interest in the account. And, they'll learn how to be investors.

Finally, one of the most valuable gifts that you can give a child is an understanding of how compound interest works. There's a huge gulf between people who are paying interest on credit cards and those who are collecting interest on investment accounts. Getting on the right side of that gulf is important.

updated June, 2017


Gary Foreman

Gary Foreman is a former financial planner and purchasing manager who founded The Dollar Stretcher.com website and newsletters in 1996. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com. Gary shares his philosophy of money here. You can follow Gary on Twitter. Gary is also available for audio, video or print interviews. For more info see his media page.

Take the Next Step:

  • Teach your teen the basics of finance management now, so they will have the tools to manage money on their own later in life.
  • It is never too early to start teaching your children the importance of saving. Compare savings and money market account rates and open an account for them today.
  • Get control of your financial life. Subscribe to Financial Independence, a free daily email that provides you with the tools to help you gain that control and achieve financial independence. Subscribers get a copy of Are You Heading for Debt Trouble? A Simple Checklist for FREE!

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