Options for investing
If you are saving for college for your child, the best place for the money would likely be a 529 plan, as these tax-advantaged accounts are earmarked for education.
Your funds grow tax-free, you don’t have to pay taxes on withdrawals as long as they’re for qualifying expenses and the majority of states offer tax deductions or tax credits for contributions.
However, if you already have a 529 and this is money meant for other things, then a brokerage account could be a good place for it.
One option is to open a custodial brokerage account, which has no income or contribution limits and withdrawals can be made at any time without penalties as long as the money is used for the benefit of the child.
You'll be in control of the investments now, and, depending on your state, the funds can be transferred to your child between the ages of 18 and 25. Friends and family can also contribute, and a portion of the earnings may be exempt from federal tax.
Once you've opened the custodial account, you'll have access to a wide range of investment options, such as individual stocks, exchange-traded funds (ETFs), mutual funds and bonds.
For many investors, a broad market index fund will be the best option, as it offers low fees and instant diversification. For example, an S&P 500 ETF tracks the performance of the 500 largest U.S. companies and is widely considered to reflect the performance of the market as a whole.
You can set up automatic investments into the fund each month as you contribute, and the growth will be effortless.
Of course, there is some risk when investing, and over time, your investment will rise and fall. However, because you won’t need this money for several years, you have the time to ride out fluctuations in the market and historically the market has always recovered and reached new heights.
The S&P has produced an average annual return of around 10% since its inception in 1957, so you should earn more than you would in a CD, and much more than you'd earn if you just kept the money in a regular savings account.
Of course, it’s critical that you review your investment objectives at least annually and rebalance your portfolio if your risk tolerance changes. And you might not want to invest the entire portfolio in equities.
You could also choose a target-date fund, with the year your child turns 18 set as the target date. Target-date funds are usually used for retirement investing, as they automatically rebalance your investments based on the timeline when you'll need the money. Unfortunately, you'd likely pay higher fees with this approach.
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Learn MoreContribute toward their retirement
You also have another option if you’re willing to think outside the box.
If your child starts earning as a teenager, you could contribute to a custodial Roth IRA for Kids for them up to the amount they earn or the annual limit ($7,000 for those under 50), whichever is lower.
You're only allowed to contribute earned income to a Roth IRA. Still, Roth IRAs allow the money to grow tax-free. Contributions (not earnings) can be withdrawn at any time tax-free and penalty-free as long they benefit the child.
If you manage to grow the account to $10,000 by your child's 18th birthday, that would turn into over $1 million by their retirement age of 67 at a 10% average annual ROI — even if they never contributed another dime.
Setting your child up for a future as a multi-millionaire may be an even more valuable gift than just putting aside a little bit each month and handing them a lump sum at 18.
Of course, if you have enough money, you could do both, putting money into both a brokerage account and a Roth IRA so you can help them both start his life and enter their later years in a great financial position.
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