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Call it the ultimate Christmas gift for your child or grandchild: a cool $1 million.
It's a lavish gift, but not a prohibitively expensive one. A monthly contribution smaller than your current cable TV bill, made faithfully until the child turns 18 and then left to simmer until retirement, will hit seven figures without outlandish investment choices.
A newborn has nothing but time -- and that's something this strategy exploits to the fullest. Let's say a 30-year-old manages to save up and then invest a lump sum of $10,000. At an annual return of 8%, by the time she's 65, that $10,000 will have grown to nearly $150,000. Not bad, right?
But then compare it to what a 5-year-old could make from the same $10,000. The extra 25 years of growth would give him over $1 million by age 65. A newborn would need just $6,700, less than the cost of a decent used car.
If you don't happen to have $10,000 handy, not to worry. You can get the same results with a monthly investment, made even smaller if you can persuade your child to keep the contributions up over the long haul.
Take a look at what's possible in the table below. All the examples presume 8% average annual growth, a reasonable return from a diversified mix of stocks, bonds and cash, according to respected financial research company Ibbotson Associates.
To accumulate $1 million by age 65:
| Starting at: | One-time contribution | Monthly contribution until age 18 | Monthly contribution until age 65 |
|---|---|---|---|
| Birth | $6,721 | $56 | $38 |
| Age 5 | $9,875 | $98 | $57 |
| Age 10 | $14,511 | $200 | $85 |
| Age 15 | $21,321 | $662 | $127 |
Pretty neat, huh? I've heard from quite a few parents excited about the possibilities. Many believe their own financial futures were stunted by not investing early enough, and want their children to avoid the same mistake.
But there's a downside. While time can help the young grow a fortune, it can also magnify any investing mistakes made along the way. If that 5-year-old's account is traded excessively, charged high fees or invested too conservatively, the nest egg may be dramatically smaller.
If our youngster eked out only a 6% annual return over time, for example, his account would be worth just $330,000 at retirement age.
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Furthermore, your kid's wealth accumulation plan could cause havoc with future financial-aid packages, so you'll want to know how to minimize the impact.
Who's a good candidate?
As nifty as the math is, you shouldn't start building your children's fortune until your own financial path is secure. That means all of the following are true:- You're on track saving for your own retirement. No matter how much you want to secure your child's financial future, you must attend to your own first. (Your kid won't thank you for your largesse if she winds up using it to support you in your dotage.) You can use MSN's Retirement Planning Calculator to check. If you're a grandparent and already retired, you should be confident you have more than enough money to get you through the rest of your life. T. Rowe Price's Retirement Income Calculator can help you decide.
- You have no consumer debt. Again, you want to be on sound financial footing yourself before helping your kids, and that means paying off the credit card balances, unsecured personal loans and any other high-rate debt. (If you've got low rates on your auto loans or student loans, though, you don't necessarily have to pay those off before you invest for your kids.)
Video on MSN Money: Open an IRA for your child
Why not? If the kid has earned income, sock the money in a Roth and the child's on the road to wealth. Click here to play the video.
- You're saving for college. That future $1 million won't mean much if your kid doesn't get a good education or winds up saddled with massive student loan debt.
- You're willing to spend some time educating your children about money. For the million-dollar plan to succeed, your children have to understand the importance of keeping their mitts off the money so it can grow. They need to know that every $1,000 they withdraw at age 21 will cost them nearly $30,000 in future retirement money -- plus any taxes and penalties that may be owed for tapping the money early.
If you've got your financial bases covered, then you can proceed.
What about taxes?
Lots of expensive financial products are sold to people who panic unnecessarily about the effects of taxes on their investments. While it's true that taxes over time can reduce your investment returns, they're easy enough to minimize without paying a small fortune in fees to stockbrokers or insurance companies.What tends to generate big tax bills is excessive trading, either by professional mutual fund managers who take a so-called "active" approach to investing or by the parent or grandparent managing the account.
There are better ways. One possibility is index funds, which mimic some broad-based market benchmark. Index funds change their lineup of investments only when the underlying benchmark changes, which isn't often.
Another bonus: Index funds are cheap, which means you're saving on fees. Instead of paying 1.4% a year, which is the average expense ratio for actively traded mutual funds, you pay:
- 0.54% for Charles Schwab's Total Stock Market (SWTIX).
- 0.4% for T. Rowe Price's Total Equity Market Index (POMIX).
- 0.19% for Vanguard's Total Stock Market Index (VTSMX).
Also, with a broad-based stock market fund, you're pretty much guaranteed to do at least as well as the overall stock market. Compare that to the two-thirds or so of actively managed funds that fail to beat their indexes over time, and you'll see that index funds are a pretty good choice.
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