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Welcome to the Stay Wealthy Podcast with Taylor Schulte. As you may be noticing, this is not Taylor Schulte. My name is Jeremy Schneider. I'm filling in for Taylor for five episodes for the end of June and beginning of July. This is my second to last episode of the five. And today, we're going to be talking about investing for kids. Specifically, I'm sharing whether you should be investing for your kids at all. Maybe it is not right for you for various reasons. But I'm going to be talking about investing for kids.
four different strategies to use to invest for your kids, how to optimize taxes and growth for those investments, and I'll also be answering two questions from listeners. So if you have kids or grandkids and you've been wondering about the different ways to financially invest for your future, this episode is for you. For all the links and resources mentioned in today's episode, head over to youstaywealthy.com slash 161.
All right, let's first tackle the question about whether or not you should be investing for your kids or grandkids at all. And so many times I get really great earnest questions from parents or grandparents. They want to do the best by their kids or grandkids.
And it's the most altruistic of goals. They want to give their kids a better opportunity than they had. They know the massive power of long-term growth with compound growth and investing, and they want to get their kids started as early as possible. But oftentimes, it's not actually right for them to be investing yet because their own finances are not in order. And so when talking about investing for kids, I have a rule called the oxygen mask rule.
And you know how if you're on a plane and there's like the little instruction manual in the seat pocket in front of you and the flight attendants say it during their safety briefing. And they basically say, if the cabin loses pressure and the oxygen masks drop, you should secure your own mask before securing your child's mask. The reasoning there being is if you try to secure your child's masks first and you pass out, then you both die.
So you get your own mask first, so you breathe. And then if your child passes out, you can put their mask on and then you both live. And so it makes sense. You got to kind of watch out for yourself first before you try to save someone else. And that applies with investing too. So if your own finances are not secure, it is not time to be investing for your kids. So for example, if you have any debt outside of a mortgage, I would not be investing for kids.
If you have no emergency fund, you don't have at least three months of cash saved up to cover your expenses in case of an emergency, I would not be investing for kids. And if you're not on pace for a healthy retirement, I would not be investing for kids because all these things represent like a critical lack of defense in your own financial setup, which could put you at risk. And then if you're at risk, you're not investing for kids.
having shoveled some of your kids is not going to help. In fact, if that is your current situation, if you have debt outside of a mortgage, no emergency fund, or you're not on pace for healthy retirement, I'd say the best thing for you to do for your kids that will make your kids the most successful financially is to set a good example for them. Don't just...
be drowning yourself and trying to throw them some cash, show them how to attack your problem. Talk to them about money. Explain the process that you're working through, why you're going after your debt first, why you're building an emergency fund, why you're investing for your own health retirement, and make sure that you're not a burden on your children later in life. You don't want to be like, give them a few hundred or a few thousand bucks when they're kids and then later in life,
have to like move in with them or something that's not the best i mean you know maybe you want to live with your kids or something i don't know if you want to but you don't want to have to need to
And if you do all these things and you get your finances secured first, you can always gift them money later. It's not like that money, you know, the money is going to be put to better use in your own finances so you can build wealth and then you can always gift the money later. So it's not like you're abandoning your kids. You're just trying to get yourself upset financially secure so you can help them more later and help them help themselves by setting a good example. Okay. So that is like the caveat here.
Don't invest for your kids if your own finances aren't secured. If that doesn't describe you and you're debt-free outside of a mortgage, you have a healthy emergency fund, and you're on pace for a healthy retirement, let's walk through the four different strategies for investing for kids. Option number one is investing for yourself. And so this is one of the
most misunderstood or most unknown facts about taxes. It's constantly misunderstood and misquoted. I'm going to give you, the listener, a little pop quiz. Did you know there'd be a quiz today? Well, neither did I until I wrote it. Here's the quiz. I'm going to ask you a question. It's going to be multiple choice. I'll give you four options. According to the IRS...
about how much is the lifetime gift tax exclusion. So this is the amount of money under which no tax is owed for gifts or estate inheritances. So how much can you basically leave to your kids or when you die or gift your kids without having to pay any tax on that gift? And here are your four options. A is $0. That means any money you gift your kids, tax is owed.
B is $16,000. That means if you give more than $16,000, and this is the lifetime exclusion, by the way. So this is how much you can give over the entire life, not just in one year. $16,000. C is $255,000. And D is 12 million. So that, again, the question is how much can you give or leave to your children over the course of your life? The correct answer is $12 million. So many people think that
the gift or estate tax is going to be... And by the way, that's $12 million per person. So if you are a married couple, that's $24 million you can give to your kids. And so many people think that
gifting money to your kids or leaving money to your kids is going to create this massive tax burden. It creates this super complex estate planning situation for relatively modest estates, like under $12 million. For most people, that's just really not the case. You can leave your kids millions of dollars or gift it to them throughout their life. There is one other tax rule, which is the annual tax exclusion. That actually is $16,000. What that number means is
is anything under $16,000 that you gift to an individual person doesn't need to be reported on your taxes at all. You don't even need to tell the IRS about it. So if you give your kids like 100 bucks or 1,000 bucks or buy them a used car or something, the IRS doesn't even ask to know about that. But if you give them like $100,000, for example, what you have to do is you have to count that
towards the lifetime exclusion that's currently at $12 million per person. That means if you give them $100,000 this year, you'd have $11.9 million over the rest of the course of your life to give to your kids. And the reason I bring this up is because most people don't really need to worry about estate taxes. And to be fair, this is an amount that changes kind of frequently and depending on
you know, who's currently in government, but it's always been in the millions or it has been for many, many years. And I think it's scheduled to go back to $10 million in a few years in 2025, I think. But the point is it's millions of dollars. And so for most people trying to avoid this estate or gift tax just isn't a big deal.
What that means is basically good news for investing for kids. What that means is you can invest for yourself in a regular old brokerage account or even in a retirement account like a Roth IRA or 401k and simply gift your kids money later. So let's say you have a $3 million 401k and you're 59 and a half years old.
you could just take a million dollars out and then gift it to your kids. If it's a traditional 401k, there's obviously tax implications there. If it's a Roth 401k, you could take it all out. But the point is that gift of the cash that you have for yourself just goes right to your kids. And if it is over $16,000 a year, it counts towards that $12 million lifetime gift tax exclusion. But it's a really nice way to basically have
ultimate control and flexibility over the investing without having to even get your kids involved until the moment you're ready to gift them that cash. In terms of compound growth, some people get confused. They think that if you have more money in a single account, the compound growth works better. If you had $10,000 in your account, it would grow faster than $5,000 in your account and $5,000 in your kid's account. That's not actually true. Two accounts with $5,000 each
in total grow at the same rate as one account with 10,000. And so keeping the money all in the same place doesn't have any mathematical benefit. But the big benefit here, or the big pro is the ultimate flexibility. It stays in your name under your control, you can do whatever you want with it. The cons are, and you know, really, the only reason not to do it this way is that it may not be tax optimal.
So some of the other accounts in which you can invest for kids might have tax benefits, which we'll go into, that don't exist in your regular old accounts. If you're someone who's not maxing out your own Roth IRA or your own 401k, it's pretty likely that's going to be your best bet and you should be maxing those out before you start thinking about it.
thinking about investing for your kids. Because like I said, you can gift that money to them later. But there are some tax benefits to these other options. Okay, so that was option number one, just invest for yourself, ultimate flexibility, control all that good stuff. Option number two.
is what's called a custodial brokerage account. It's just like your own brokerage account, but it's a brokerage account for kids. Custodial means you're the custodian of it. You manage it for them while they're children. There's laws that dictate how these work. And you might have heard the terms UGMA or UTMA, U-G-M-A and U-T-M-A. Those stand for the Uniform Gift to Minors Act and the Uniform Transfer to Minors Act. These are basically the laws, and it varies a bit by state to state, but the laws that
cover how a child's investment account works. Basically, the way it works is you go to a brokerage like Vanguard, Fidelity, or Schwab. You open up a brokerage account in your kid's name. You'd search for a custodial brokerage account or an UGMA or UTMA account. You type in their information, their social security number, and then your information as a custodian. And then you can invest. You can buy index funds or ETFs in that account for your kids. The
The benefits of this, the pros of using one of these accounts is that there's a modest tax benefit. Basically, the growth and income from the investments will be taxed at the child's tax rate. And often that's zero because many children don't have income. And so if they only make a few hundred bucks or even a few thousand bucks of growth of their investments, even though it's in a taxable account, there is no tax on such a small amount of income. And so that gets to basically grow tax-free.
Also, another benefit is very flexible use.
While they're a child, you can basically use it for anything to the benefit of the child. If they're under 18, you can use it for school. You can use it to buy them sports gears. You can take them on trips, anything that's for the benefit of the child. You can't steal it from them. It's still in their name. Just like you can't take money out of your sister's bank account or your neighbor's bank account. You can't steal the money, but as you're the custodian, you can use it for the benefit of the child. Those are the pros. It's taxed at the kid's rate, and it's flexible in how it can be used.
The cons are as follows. One is that the child owns the money. And once that money is in there, once that money is contributed to that custodial brokerage account, it is irrevocably owned by the minor. When your kid turns 18 or 21, depending on your state, they can legally do with it whatever they want.
you have no say. And so for example, if you are plowing tens or hundreds of thousands of dollars into a custodial brokerage account because you want it to be taxed at a more favorable rate, and then they turn 18 and they want to do something you don't agree with, too late. It's their money. You've already given it to them. You can't steal it back. So that's con number one. Con number two is it may impact college financial aid.
So if you are planning to seek federal financial aid, the FAFSA formulas consider 20% of the money in these custodial accounts available to pay for college. And so it doesn't actually make these ideal accounts to pay for college. A 529, which is designed specifically to save for college, is probably a better option, which we're going to talk about right now.
So just again, to recap, option number two is a custodial brokerage account. The benefits are a modest tax benefit and flexible on what it can be used on. The cons are the child owns the money free and clear the day of their 18th or 21st birthday, and it may negatively impact financial aid. That takes us to option number three, which is a 529 plan. I don't really love the word plan. I feel like plan just like makes things overly complex. It's just an
an account like a checking account or a savings account. And this one is called a 529 account because it has some special rules. It's what's called a qualified tuition plan. And it's basically an account that you can use to save for college for a chosen beneficiary. Note that it doesn't have to be a child in this case, you can even have yourself as a beneficiary or someone else. And once you establish a 529 account, you can change who the beneficiary is.
But the benefit of the 529 is that you put money in there after tax, but then it grows indefinitely tax-free. So it works like a Roth. It works like a Roth IRA. But instead of
being designed for retirement and there being an age restriction to withdraw this money, there's actually a use restriction, which is it's limited to educational expenses or qualified educational expenses. Basically, this is really designed to pay for college tuition and college expenses. But if you go to private school or you have... And the list of what counts as a qualified educational expense is relatively permissive. And so if you have a series of other educational expenses...
saving in this type of account might be ideal. The benefits are there's a solid tax benefit. The growth and income of the investments will be tax-free as long as the money is spent on educational expenses. Another pro is that there's no income limit. So if you are a high income earning parents or grandparents, you can funnel some of your money into this tax advantage account no matter what your income.
And the last benefit is there's really high contribution limits. Basically, you can put as much as you want into a 529, but not more than what's called the amount necessary to provide for the qualified higher education expenses of the beneficiary. So it's not used to like launder money or, you know, stash money, millions and millions of dollars to try to like get that later. But you can basically fully fund a college education through a 529.
The big con is that it's limited to educational expenses. And so, for example, if you save $50,000 in one of these and it grows to $100,000 over the course of your child's or grandchild's life, and then they decide not to go to college and they become a TikTok influencer and just go straight out of school and start living their life.
you might do taxes and penalties for having all this money in there if you try to get it out. One of the flexible options is you can change the beneficiary. So if you have several kids or grandkids and the oldest one doesn't use it, you can just kind of flop it on over to the next one. But you might want to be careful about that if...
you don't think your kid or grandkid is likely to go to college. And again, you know, investing for yourself in a regular brokerage account, option number one is a perfectly reasonable way to invest for college. You know, the big negative is you don't have that tax free growth, but you do have the ultimate flexibility. So it's something to consider. How do you open a 529? Well, 529s are kind of weird. They're run individually by all 50 states.
And generally, the rule is you don't need to open a 529 in the state where you live. And you don't need to open up a 529 in the state where you go to college. So for example, you could like grow up in Michigan, like I did open up a Connecticut 529, like I did, and then go to school in California. Like I didn't, I went to school in Michigan. But just for sake of argument, all three of these things where you live, where you go to school, or where the beneficiary go to school, and where the 529 is located, can all be in different states.
Why is it state by state? I don't know. Basically, I don't really fully agree with any of the government rules around these tax advantage accounts because they're overly complex and just cause headaches. But that's the way it works. And so how do you actually do it? Well, you can go to a brokerage like Fidelity, Vanguard, or Schwab, click open a 529. It is going to make you choose a state there, but they basically choose states that work really well. I think Fidelity's default is New Hampshire because it just has really good flexibility and nationwide...
access and all that good stuff. And so actually, that's what I did. I opened up a Fidelity 529 account that's technically through New Hampshire. And then once you open the account, it does make you choose your investments. And it varies based on the brokerage, but it kind of feels more almost like a 401k where you're choosing from the available options, not like an IRA where you can like day trade inside of it and stuff like that. But it's one of those things like once you go to the website, click open a 529 and follow the steps. It's relatively straightforward, but it is
potentially intimidating the first time you hear about due to the series of very scary sounding numbers and states involved. But once you do it, it's really not too bad. Okay. And that brings us to option number four, strategy number four, which is a custodial Roth IRA.
And so hopefully you're familiar with the Roth IRA. It's a retirement account where you can put money in and it grows tax-free forever. And then you get unlimited access to it when you're 59 and a half years old. But there are some restrictions on the Roth IRA. For example, you can't put more than $6,000 a year in. And you also can't put more than your modified adjusted gross income, basically your earned income that you have during the year.
And so it's designed for working people to save for retirement in a tax-free account.
For kids, most kids don't have jobs. They don't have earned income, you know? And so this isn't an option for most kids because they're kids and they're not like paying taxes. They don't have a W-2 or any earned income. But if you have like a teenager, like a 16 or 17 year old who gets their first job and maybe makes a couple thousand bucks as a parent, what you could do is
either encourage them to put their own money in or you could even gift them as much money as they made that year to basically max out their custodial Roth IRA. In fact, I'm 41 years old when I was, I think,
I think 16, I had my first job. And that was right around the year where the Roth IRA was introduced in the late 90s. And my dad actually very cleverly did this exact thing for me. When I had my first real tax payable paycheck, I think it was $1,200. He basically gifted me $1,200 and said, hey, you can keep the money you earned. I worked at a summer camp. So he said, you can keep the money you earned for working at the summer camp.
And I'm going to take this $1,200, gift it to you, and then we're going to contribute it together to a custodial Roth IRA. And that money was put in that account, invested in some mutual funds, and then allowed to grow until this day. And now I have over $100,000 in that Roth IRA plus all my other investments, of course.
This is a really good option. It's actually kind of my favorite option because it just gives you this unlimited, like super, super long investing timeframe for kids with no worries about taxes. It's pretty flexible in terms of retirement accounts because you can take out the principal if you want to, stuff like that. So the pros are, yeah, the great tax benefit. And the other big pro is it encourages long-term investing. And so unlike a custodial
brokerage account, which kind of feels like it's a free for all 18, at least the Roth IRA has some guardrails in place until 59 and a half. And also that even better tax benefit than the custodial brokerage account. The negatives to the custodial Roth IRA are that your kid needs earned income. You got to have a job. It doesn't work for babies. Maybe if your baby's modeling or something, they're actually on the tax bill. And I've seen some influencers suggest
paying your kid, like putting your kid on payroll so that you can get a Roth IRA for them. But honestly, that just feels like you're asking to be audited if this isn't like a legitimate job. And so I would not...
willy-nilly suggest that. You might want to talk to your tax professional before you're just like giving your kid a random job that isn't a real job because when that audit comes and they find out your baby's on the payroll for being a janitor or something, it's probably not going to look too good. But if it's a legitimate job, it's a good option. And the other con is just the cons associated with a Roth IRA, which is generally they don't have free access to it until they're 59 and a half. You can, of course, access the principal tax and penalty free at any time, what you put in. But if you have other plans with money like
a home down payment or college, or you just want your kids to buy a boat in their 20s or something like that, the Roth IRA might not be the best option. Okay, so there are your four strategies for investing kids. The invest for yourself and just gift them money later. Take advantage of that $12 million gift tax exclusion. The custodial brokerage account, also known as the UGMA or UTMA. Option three is the 529 plan. And option four is the custodial Roth IRA.
That is how you invest for kids. I hope that was helpful. And if you are in the position to help your kids or grandkids get a head start in life, that would be amazing to do so.
That brings us to our questions from listeners segment. Our first question comes from Justin from Yorba Linda, California. Hi, Jeremy. My name is Justin from Yorba Linda, California. Big fan of your work. I had a question about HSAs. I understand that an HSA can offer a triple tax advantages. However, it's different in California, I read. Could you elaborate on that a little bit more? Thank you. So we just talked all about investing for kids.
Justin's question is about the HSA, the health savings account, which is yet another type of tax advantage account. But instead of investing for kids, it's basically used to, it's designed to pay for healthcare needs. And he does mention the triple tax benefit. The triple tax benefit of the health savings account is money that goes in,
is tax-free. So for example, if you make $60,000 a year and you contribute $3,000 to an HSA, the federal government taxes you as though you only made $57,000. So that $3,000 comes straight from your income directly into your HSA. The second tax benefit is it grows tax-deferred. And so you can actually invest the money inside of an HSA. And then if you have dividends or you sell for a capital gain, that isn't taxed.
And then the third tax benefit is if that money is spent out of the HSA on a qualified medical expense, that isn't taxed. And so there's basically no other...
tax advantage account where you can put money in tax-free, it grows tax-free, and you spend it tax-free. There are some restrictions, of course. You can only put in a certain amount of money in there. In 2022, that contribution limit is $3,650 for an individual or $7,300 for families. And of course, the money in order to get that tax-free benefit is
has to be spent on qualified medical expenses, which certainly is a restriction, but people often later in life have plenty of those things. And at age 65, it converts to basically a regular traditional IRA where you can take out the money for anything you want. So it's actually a pretty nice option. And so Justin is asking,
This is different in California. And he's right, kind of. There's not like a different account or anything. But basically, in 48 states in the US, the states have said, hey, we agree with the federal government. HSAs exist. Like those three tax benefits exist.
our state taxes are going to conform to federal taxes, just as we do with traditional and Roth IRAs, just as we do with traditional Roth 401ks and basically all the other tax advantage accounts. But for some reason, in California and New Jersey, those two states haven't conformed to the federal tax rules and HSAs, which means...
From the state tax perspective, it's just a regular old brokerage account, which means if you sell for a gain or get a dividend, et cetera, et cetera, you have to pay tax on that. That's theoretically not that big of a deal because it's still good to get the federal tax break. And then if you're investing inside of your HSA, the growth is still good even if you pay a little bit of state tax, but does kind of introduce...
a potential logistical tax accounting headache. Because as far as I know, and the HSA I have, which I invest inside of is with Fidelity. Fidelity doesn't provide a 1099 for HSA because Fidelity is basically just following federal rules and saying, hey, this is a tax advantage account. You don't need to worry about the dividends, the distributions, the capital gains, a lot of stuff. And so in order to basically correctly file your California taxes,
You need to keep track of every purchase, every sale, every gain, every distribution. If you're reinvesting dividends from a mutual fund, for example, inside of your HSA, all those little tiny dividends and repurchases are going to create different tax lots, which are going to have to be kept track when you sell. If I'm making this sound like a nightmare, it probably is. And frankly, it's probably a conversation you should have with your CPA if you are investing inside of your HSA and paying state tax in California and New Jersey.
Is the state of California going to know you have an HSA? Yeah, maybe because there's other tax forms that might show that. Or if you have it through your employer, they might be reporting that as an HSA contribution. You know, for what it's worth, there was actually a bill introduced in California, AB 2384, which would just fix this. In fact, it would fix it and then some.
That bill introduced in 2020 even said that unlike federal law, the bill would not impose an additional tax for distributions used for non-qualified medical expenses. And so this bill was introduced in 2020. And as far as I can tell, it also died in 2020 from like March, November. And so unfortunately, if you live in California, you still live in this kind of sticky HSA state tax situation.
What do you do about that? You either try to file your taxes correctly. You could just not invest inside of your HSA and just keep everything in cash where you don't need to worry about. You could invest very simply with one fund where you don't reinvest dividends. There's very few transactions you need to worry about. But if you have big money in your HSA that you're investing, it's probably something you should be at least aware of. Great question, Justin. Hopefully, we all learned something about California and New Jersey HSAs.
Our next question comes from Jasmine from Richmond, Virginia. Hey, Jeremy. Do you think it's ever okay to have a car payment? My car is on its last leg and I only have $17,000 to put down. So I'd probably have to finance about $20,000 and I would definitely pay that down aggressively. Let me know your thoughts. Thanks. So Jasmine knows that I'm not a big fan of debt.
I believe that borrowing money to buy a depreciating asset is a really good way to lose a lot of money and lose a lot of wealth. So she's basically asking my permission to borrow money for a car because she only has $17,000. Even the way she worded that question, she said she only had $17,000 and she's going to have to borrow money. And I would dispute that. I personally drove a $3,000 car for six
six years from age 30 to 36. And before that, I drove a $9,000 car. And before that, I drove a $5,000 car. I didn't spend over $10,000 on a car until I was, I think, 36 or 37 years old, and my net worth was over $3 million. And so, yeah, Jasmine, you can totally buy a car in cash for $17,000. You can even buy a super nice car. If you have your heart set on a brand new car, you could buy like a $15,000 car, drive it for a couple years, sell it for
12,000 because cars don't lose that much value in two years. And then take that 12,000 plus the money you've been saving for two years, which
since you said you're going to pay down the debt aggressively, then use all that to buy a car. So there's one option. But yeah, for me, like I wouldn't do it. You know, Jasmine, you can do whatever you want. You don't need my permission or my blessing, but I don't think buying the new car is a necessity. I think also when you are forced to pay cash for a car, it changes your view of the price of that car, right? Car dealerships love to get you on a, you know, a monthly payment.
When you walk into a car dealership, they give you a bottle of water and a cookie and they draw a little square and they say how many months and how many dollars and they try to like talk you into a monthly payment. You think, oh, I can afford 500, 600. Then you walk out of there with a $583 car payment that's going to last 72 months and you're just...
burning your income for like five or six or seven years. These car payments keep getting bigger and longer. But because it sounds like a small amount of money monthly and that you can afford it, you basically are giving up this massive amount of opportunity, of growth, right? And if you are forced to pay cash, like if I handed someone $30,000 and said, okay, here's money for a
maybe they wouldn't buy a car for $30,000. Maybe they'd say, you know what? What if I just buy a car for $20,000? There are lots of nice cars. I mean, to be fair, I'm recording this in May of 2022 where buying cars is the worst it's been in my entire life. Used car prices, new car prices, everything because the supply chain issues are through the roof. And so I'm not trying to mitigate the challenge of buying a car now, but I promise you, you can still buy a car for $70,000 and even less. It might not be a brand new car with all the bells and whistles you want, but
whether it's a used car or new car, two weeks later, they're all going to be used cars. It's just another used car. And so for me, Jasmine, no, you don't have my blessing. If I was in your shoes, I would be buying like a $14,000 car and then saving up for a few years and then seeing if you want to upgrade then. But you can drive a perfectly nice car for $70,000. So yeah, you didn't trick me this time, Jasmine, but thank you. And by the way, if you want to borrow money for a car, I'm sure you'll still live a long, healthy, happy life. I'm not trying to shame you for your choices, but that's not what I would do.
All right. That is the end of the Q&A section. And that is all I have for you today. For the links and resources mentioned, head to youstaywealthy.com slash 161. And again, thank you as always for bearing with me as I fill in for Taylor. I will be back next week for my very last episode of this year. And I'll leave you with my two rules of building wealth. Rule number one is live below your means. And rule number two is invest early and often. See you next week.
This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.
