According to the United States Department of Agriculture (USDA), the average cost of raising a child rose to over $222,000 in 2009. (1) The 2010 annual Expenditures on Children by Families report revealed that the cost of raising a child rose by less than 1 percent from 2008. A big portion of this expense goes towards paying for college. According to a report published in the Christian Science Monitor, the cost of college has risen 440 percent over the past 25 years, four times higher than the inflation rate. (2) The schools with the best reputations cost upwards of $200,000 for four years.
Parents have to start planning early to invest on behalf of their children. Starting an Individual Retirement Account (IRA) or a 529 savings plan or other tax-advantaged account will help parents provide for their children when they come of age. In tough economic times, planning ahead for favorable and unfavorable circumstances is paramount to helping one's children have a successful life.
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Setting Up An Account
Three questions must be answered. Who will own the account? What type of account will it be? What kind of assets will the account hold? These questions will decide the entire account ahead of time, avoiding confusion and errors due to changing circumstances. The goal of the account is to accumulate the largest amount of cash possible after taxes while compensating for inflation. A secondary goal is to teach children about investing as they grow older.
Generally speaking, it is best for the account to be in the parent's name but have a legal structure in place that transfers it to the child when he reaches the age of maturity. A custodial account answers this purpose very well. A custodial account's earnings are taxed at the child's tax rate instead of the parents’. In other words, taxes are practically nonexistent, allowing 18 years or more of compounding returns.
Retirement
The stock crashes of 2000 and 2008 wreaked havoc on the portfolios of future retirees. Subsequently, most of them have had to postpone their retirement dates or cancel them completely. Traditional IRAs and Roth IRAs are both tax-advantaged, but a Roth IRA is more flexible which can help when raising a child. The contributions, but not the earnings, from a Roth IRA can be withdrawn tax-free at any time for any reason. Traditional IRAs impose a 10 percent penalty for the same action.
Unfortunately, only $2,000 per year can be contributed to a Roth IRA. What's more, if the Roth IRA will be in the child's name, he has to earn money in order to have one. This means having a Roth IRA in the child's name is not feasible until he is old enough to work.
Saving for College
After retirement, the next most important goal is college. Again, the cost of college has risen four times faster than inflation over the past quarter century. One of the easiest ways of saving the amount needed to pay for college is a 529 plan. Signed into law in 1996, a 529 plan's earnings accumulate and grow tax-deferred. Distributions for educational expenses are tax-free and penalty-free. The 529 plan is a state-sponsored plan, which means that the state sets up the plan with an asset management company. The parent then opens a 529 account with the company.
529 plans actually come in two types. The first type is the tax-advantaged account, and the second type allows the parent to prepay tuition by purchasing credits at current tuition rates for the beneficiary. Most parents prefer the tax-deferred account to take advantage of compounding returns.
References
(1) http://www.cnpp.usda.gov/Publications/CRC/2010CRCPressRelease.pdf
(2) http://www.csmonitor.com/layout/set/print/content/view/print/402577
Tal Baron writes for Currensee, a FOREX trading social network offering some of the best investments in currencies.
I opened a Roth IRA for my son a year or two ago, and he’s been able to contribute to that. That’s always a nice option since the money grows tax free, and a child is rarely paying taxes anyway to start with.