How to Start Investing on Behalf of Your Baby

My mom is big into investing in lieu of giving gifts. Shortly after each of her grandchildren was born, she opened up a brokerage account and invested in a mutual fund for them. Every year at Christmas and on their birthdays, rather than buy toys, she puts cash in the account. She does the same for the adults in the family too, but we receive shares of stock. She’s been doing this for 20 years, and we love it. We’re lucky to have someone invest for us.

However, what if a parent wanted to start saving and/or investing for their own new baby? What’s the best way to go about it? With college, cars, and who knows what other expenses coming down the road, it can’t hurt to start squirreling money away for your kid now, right? Assuming, of course, you have the extra disposable income. But is a mutual fund or shares of stock the way to go? How about a 529 plan, gold, savings bonds, or a simple savings account? What’s the smartest plan of attack?

It’s a complicated question. And there’s no one answer. So, to find out how to effectively start saving or investing on behalf of a new baby, we asked two financial planners with expertise in family finances ⏤ Robin Taub, CPA, CA, and author of A Parent’s Guide to Raising Money-Smart Kids and Matt Becker, a Florida-based CFP and the founder of Mom and Dad Money ⏤ for some tips. Here’s what they recommend.

First Off, Ask: What Is the Money For?

The first question to ask is why you’re saving the money. Is it for college tuition? A new car when they turn 16? Maybe you just want to send your kid off into life with a small nest egg, so they don’t end up moving back home. Who knows. But figuring out now where the money will go is the first step, says Becker, and that answer should determine the type of account you set up.

“It all depends on your goals, time horizon, and tolerance for risk,” adds Taub. “Sure you could do a simple savings account, but you know how little a savings account pays now, less than one percent. What’s that going to really add up to over time, not much.”

If You’re: Saving For College

Invest In: A 529 Plan

Why: If the money’s definitely going to college tuition ⏤ no ifs, ands, or buts about it ⏤ then a 529 Plan is likely the best route. “It offers the greatest number of tax breaks and also the fewest limits on contributions,” says Becker. “Plus, the money grows tax-deferred and can be withdrawn tax-free, assuming it’s used for higher education.” Not only that, but there are no income limits (so you can contribute regardless of your salary level) and there technically aren’t annual contribution limits ⏤ although you will get hit with a gift tax if you contribute in excess of $14,000 per child ($28K for married couples) this year, or $15,000 in 2018.

The biggest drawback of a 529 Plan, says Becker, “is that if you don’t end up needing the money for college, or you want to access the money sooner, you’ll be taxed on the account’s earnings and hit with a 10 percent penalty if it’s used for anything other than higher education expenses.” And while there are some workarounds ⏤ for example, you can change the beneficiary from Kid A who isn’t college-bound to Kid B who is, or even name a future grandchild as a beneficiary ⏤ overall, it’s more strict than other investment vehicles. “It’s really more of an issue if you decide you want the money for something else,” says Becker. “Then there be a 10 percent penalty on the earnings. That’s the biggest drawback.”

If You’re: Saving For Other Education Expenses

Invest In: A Coverdell ESA

Why: If you like the idea of saving for school but don’t necessarily want to be tied to college, then there’s also a broader education savings account known as a Coverdell ESA. “It’s similar to a 529 Plan in that you contribute the money after taxes, there’s no tax deduction for contributions, and the money grows tax-free,” says Becker. “The big difference is that it can also be used tax-free for K-12 expenses including private school, tutoring, books, and other necessary tools and supplies.”

While it offers more flexibility in terms of how the money is used, the Coverdell ESA does come with stricter income and contribution limits. Not only are you out of luck if you’re a married couple making more than $220K, but it caps total contributions per child at $2,000 a year across all contributors. “So if grandma and grandpa contribute $1,000 to your child’s Coverdell ESA during the year,” Becker says, “You can only contribute up to $1,000 more. Because the total contribution can’t exceed $2,000.”

If You’re: Saving A General Nest Egg

Invest in: A “Couch-Potato Portfolio”

Why? Assuming you just want to sock money away for general use down the road, it turns out mom’s way, like many things in life, is the best. “The easiest option is to set up a really simple, what I like to call, a couch-potato portfolio from any big bank and invest in an index mutual fund like the S&P Index,” says Taub. Index funds are broadly diversified and improve your chances of not picking a loser, the way you might if you bought individual shares of a company’s stock. Just be sure, she adds, to set up the account for the child in your name.

Becker agrees with Taub, recommending parents open a low-cost brokerage account from a company like Vanguard, but keeping the account in your name. “There are ways to do trust accounts and things like that but there’s no need to,” he says. “Just keep the money in a separate account in your own name and contribute as much as you want to it.” He adds, “there are no special tax breaks but also no contribution limits or limitations on when you can access the money.”

In terms of how to allocate the money, again it depends on your timeframe and aversion to risk. “Keeping the money in low-cost index funds is the best way to maximize the odds of growth,” Becker notes, although with a caveat. “If it’s just money for general future use, and there’s no particular timeline or anything you’re saving for, you can afford to be a little aggressive with it.” Although being aggressive doesn’t mean getting crazy and buying gold or bitcoin futures. “I’m not a fan of gold,” he says. “Nor am I a fan of life insurance policies Gerber tries to sell new parents for their infants. It’s basically a whole life insurance policy with a lot of fees that they claim will double in value within X number of years.” Steer clear he says, “No gold, no life insurance.”

Whatever You Do, Save For Yourself First

Both Taub and Becker offered a final word of warning to parents who might get carried away saving for their 6-month-old: Don’t prioritize saving money for your child, even for college, over saving for your future. They acknowledge that if you have extra income after saving for retirement, by all means, help set your kid up for a successful future. But remember: the biggest financial gift you can give them is to not move into their basement when you’re 80-years-old. Simple as that. “Focus on your own finances, paying off high-interest credit card debt and mortgage debt, and saving for retirement,” says Taub.

Becker gives his clients the same advice, especially when it comes to saving for college. “I actually recommend making college savings one of the lower financial priorities,” he says. “There are a lot of different ways to fund a college education. Other than Social Security, however, there’s really no other way to fund your retirement than saving for it now. And the sooner you start and the more you save now the better off you’ll be.”

“It’s the whole oxygen on the plane scenario,” he adds. “You are making it easier for your child if your own personal financial foundation is secure, because they don’t have to worry about you. It’s not just selfish, it’s actually a great gift to your children to save for yourself and secure yourself first.”