December 1, 2022
The Stockings Were Hung By the Chimney With Care… Why Not Fill Them, With “Valuable” Shares?
So clever… This update is directed toward parents of young adults looking for a solid game plan to help their children get started early with investing. What an incredible gift we have before us; To get the right types of accounts set up, funded and invested while there are still multiyear investment opportunities to be had.
First let me start with a little shaking of my head in disbelief. Why is it that we all charge out to power shop on Black Friday or Cyber Monday to take advantage of deals on consumable, discounted stuff but show no interest in buying shares of public companies trading at multiyear valuation lows? Which one of these will be the better investment in 10 years; A pair of Chuck Taylor high tops at $199 (on sale from $249) or putting $199 into any number of stocks paying 5% dividends with 10-15% annual growth in earnings per share? I’ll bet the shoes are in the landfill by year two. Seriously, think about this as the gift that keeps on giving this holiday season. Your kids will not even remember the high tops but they will fondly remember you when they can thankfully afford a down payment on their first home.
Ok, let’s do some smart shopping.
Set Up Two Types of Accounts for your Kids
This is some conditional advice so please reach out to get clarity on your specific situation. Broadly speaking, a Roth IRA for a Minor (Aka custodial Roth IRA) is a great first account to get set up. Any major brokerage shop like Fidelity or Schwab has on-line tools to help you set this up in a few minutes. The condition here is that your child is under 21 and has some form of earned income. This income can be from a summer job with regular w-2 income or even baby-sitting, mowing lawns etc with some limitations. Some think you need to file a tax return for your kids to be eligible to set up a Roth IRA. Not so!. Unless your child earned $12,550 or more in 2022, there is no need to file a tax return. My kids generally make between $3-5K in summer jobs so they are no where near the threshold. But, they are still eligible to contribute the lesser of their earned income or $6000/ year to a ROTH IRA.
Details to Remember About Roth IRAs
- There is no tax due on their earned income (if under $12,550), so we are not trying to fund a traditional IRA with deductible contributions right? Thus we are making NON-deductible contributions to a Roth IRA.
- Roth IRA money grows tax FREE. At their age, they might have 40 years of growth in these assets that will never be taxed.
- Roth IRA money cannot be accessed without penalty until age 59.5. They cannot buy a sweet Camaro with this money, it is for their retirement.
The second account to set up is a taxable UGMA/UTMA (custodial) account. This is an account that they can access and will formally own under their own name at the age of majority in your state. In Colorado, that age is 21. Unlike the Roth IRA, realized gains and income are taxable and will add to their “earned income” each year so you need to be careful about staying under that $12,550 number unless you care to file a tax return. There are again different thresholds for how income and capital gains are taxed in these types of accounts. Here’s a great cheat sheet from Fidelity on all types of custodial accounts, including rules, limits and taxation. The point of this second account is to provide them with starter money, out of school, that they can use for a down payment on a home, maybe to cover rent, go to graduate school, etc. I would spend a little time having open conversations with your children about the purpose of this money. It will be theirs but is to be used responsibly and for their financial foundation and not for consumable items or entertainment. If you have concerns along those lines or children with disabilities, talk to us about setting up a trust.
Who is Funding These Accounts?
In either case, the source of the funding doesn’t matter which means you, as the parent, can help them! Enter the teaching moment. This is the “deal” we have with our two boys with the clear intention of developing good financial habits with saving and investing. At the end of every summer, we match 100% of their annual savings toward their investment accounts. My sons typically save 25-30% of their summer incomes toward investment accounts. In our example, they might choose to save $1000, we match the $1000 for a total of $2000. Often, they split the total savings equally between their Roth IRAs and their custodial UTMA accounts – some to long term, some to short term. Suddenly, they have skin in the game and want to start talking about what types of investments they can buy, what should they buy, how do they build a complete diversified portfolio, what does a bear market feel like, etc…? Good stuff to learn at an early age. More importantly, they develop a habit of saving annually for themselves and their futures. Side note – I have strong opinions about the risks and bad precedent of handing your kids lots of money, open credit cards, and paying for everything without them having to bring anything to the table. You are digging a very deep hole of dependence let alone stealing your kids’ right to any sense of pride in making it on their own. Teach them to fish right….
How to Invest These Accounts?
Roth IRA – This is long-term, tax-free money so let’s invest it that way. In this account they should own mostly stocks and seeking growth or combinations of growth and high income. We have low cost ETF asset allocation models that we can provide to you if you simply want to own 7-10 total positions and build an aggressive portfolio on a set it and forget it basis. Please ask! There are also some developing options for the gamers out there. I think 2023 will provide us with several generational opportunities to buy individual stocks with a portion of this account. My kids have about 20% of their Roth IRA accounts in individual company shares with the rest in index ETFs. They have been doing some buying recently in names like Airbnb (ABNB), Bloom Energy (BE), Zillow Group (Z), Snowflake (SNOW), Block (SQ) and Wayfair (W) with Rivian (RIVN) and Uber (UBER) on the watch list. These are stocks that we have talked about and are now trading 60-80% off their highs. Some may do nothing, some may not exist or be purchased in the future. But some may do Amazon type returns in the next 40 years! There will be more opportunities like these in 2023. The rest of their portfolio is fully diversified across equity ETFS and high yielding closed-end funds. These accounts will be substantially larger by the time they are 59.5 years old.
Custodial UGMA/ UTMA – For these accounts, we want to be a little more cautious with sensitivity to capital gains and taxable income. This is shorter term money that needs to be there for them when they are done with schooling. Here we like to own a fully diversified portfolio of stocks, bonds, commodities, gold, internationals, income and real estate funds. We want to lean into value and lean away from speculative growth. These positions are to be bought and held with a focus on adding to positions when they present discounts in order to limit risk and taxable gains. Are there any discounts in the markets now? You betcha.
Final Thoughts on Risk and Return
This is a good conversation to have with your young adult children. There is a notion in the financial media that more risk equals more return over time when it comes to security selection. This is patently false. More risk is just more volatility. Now, if over time, volatility is in the form of higher prices, then good for you and honestly the broad markets do tend to rise over time. As long as you have at least 20 years of investment time horizon, your odds of success are nearly 100%. However, as evidenced by the number of popular names that have experienced wipeouts in the neighborhood of 80-90% this year, risk can also mean downside volatility. How long does it take to break even on an investment that loses 90% of it’s value? Let’s say, not in your lifetime. Any company that goes through this type of loss of capitalization and price decay is either on its way to bankruptcy or a buyout. Timing matters, what you buy matters, profits and balance sheets matter, valuations matter. Last year, we watched the Superbowl played inside the Crypto.com stadium. Laughable. Why is anyone surprised that Crypto turned out to be an enormous dumpster fire of an investment. Concentration of your wealth in just a few companies is simply leveraging the concept of risk. Nothing is forever and there is no guarantee of success with any company even over the long term.
When investing with your kids, perhaps the greatest gift is the gift of knowledge. Use real investment accounts and savings habits as a mechanism to teach them how to be mature investors, including the beneficial principles of diversification, patience, humility, and solid behavioral practices like buying when share prices are down and cheap.
… and to all a good night
Sam Jones
