A few of my excuses might become blog posts in the future.
We’re finishing up a road trip to Florida, and I have actual time to write. (yes, we drove from Maryland…see why I like $5/gal gas). One daughter is sound asleep. The other recently learned how to braid and is braiding everything in sight. At least it’s a quiet activity….
I’m reflecting on our whirlwind trip. Ok, I was scrolling through Mint and seeing just how much our whirlwind trip cost us. Instead of sweating the dollars, I realized this is exactlywhy we have worked hard, saved, and invested for years! And that’s what prompted me to put quill to parchment again.
For the record, we rented a mini mansion with two other families and filled it with laughter and joyfully squealing kiddos, lazed away a couple of afternoons bobbing around the resort river, completely throttled two Orlando area theme parks, and visited with family.
If this were Instagram, that would be the only perfectly coiffed image you would get.
But we weren’t quite so polished when our over-tired two year old raced off, red shoes a blur, through the packed theme park restaurant dodging patrons better then Rogue 5. Our first warning that something was amiss came from a staff member yelling, “we got a runner!”
Nor was I ecstatic when my little ones both turned up their noses at the tepid, slightly sulphury Florida tap water I had filled their reusable bottles with. I gritted my teeth and shelled out $8(!) for two nicely chilled plastic bottles of filtered water. But I totally poured the purchased water into their reusable bottles first…
So much of the personal finance space is full of tactics for how to get a certain number of dollars in some accounts. And, we’re not going to neglect our financial journey either. But sometimes, we miss out on the real purpose behind all that working, saving, and investing.
Yes, we’re exhausted from the trip. Yes, our wallets are lighter. Yes, we had plenty of aggravating moments. But our hearts are full.
My girls will have awesome 21st birthday parties if they want them. Or, they will have startup capital, weddings, house down payments, or gap years. How, you ask? Some modest investments, time, and dependent capital gains harvesting.
Investing In Your Child’s Financial Future
When my oldest daughter was born, her uncle Dan gave her a gift of $100 with the following instructions:
New Baby-
Tell your Dad to open an investment account for you (if he hasn’t already) and put this cash into the account. When you turn 21, you can have a big party with all your friends!
Uncle Dan
Any time she received money from other family members, we bought more of Vanguard’s total stock index ETF, VTI. Turns out infants don’t really need much more than diapers and onesies. So, we asked family members for any gifts during her first few years to be cash too. I also split up my 529 contributions so that every paycheck I put a bit more into this account instead of the 529.
Over time, we just kept adding more shares. Once her account crossed $3,000, we converted it to Vanguard’s total stock index fund, VTSAX and set it to auto purchase a little bit each pay check.
It has been a very positive 5 years during her investment career. I looked at my records and plotted the historical growth of her UTMA account. Being a nerd, I also extrapolated 3 scenarios into the future:
At the low end, we’re just contributing $300/yr and the account grows at a rather paltry 3%.
The nominal scenario has us contributing about $850/yr with the account growing at 5%.
In the high scenario, we’re adding $1700/yr and it all grows at 7%.
Three potential growth scenarios for a child investor
It’s a proud papa moment when my almost 6 year old is able to peer into her young adult years and have between 25-95k in capital at her disposal. Thank you, Uncle Dan!
Now for the fun part: Dependent Capital Gains Harvesting
As the market moves up and to the right, I periodically sell VTSAX and buy something similar like Vanguard’s S&P500 index fund, VFIAX. This is a taxable event. We sold shares for a profit, and my daughter, our dependent, owes capital gains taxes on her earnings from the sale. Note: to keep things simple, I’m assuming no other types of income (no dividends, no interest, no earned income).
For minors in 2023, the IRS taxes capital gains on up to $2200 of unearned income per year at 0%. My oldest daughter is almost 6. This is her only source of income. While she is our dependent, as long as she doesn’t profit more than $2200/yr, she owes nothing on the gains for that year.
Once she is no longer our dependent, she will be eligible to pay “filing single” capital gains taxes. Let’s pretend that we’ll flip that switch when she turns 18. That may not reflect reality, but it’s an example. In 2023, for individuals filing singly, the IRS capital gains tax rate on up to $40,400 of taxable income is 0%. Let’s take the low balance scenario and see what her cost basis looks like at 21. Remember, we’re making some assumptions here:
Selling enough shares each year until she turns 18 to lock in $2200 of capital gains with 0$ of taxes owed
After she turns 18, selling enough shares each year until she turns 18 to lock in $40,400 of capital gains with 0$ of taxes owed. OK, this may not be as realistic, but it should illustrate the point
A Deeper Look At The Scenarios
Using capital gains harvesting for a dependent while she has $0 of other income, by the time she reaches 21, the entire balance of her after tax account will already have had the capital gains taxes paid…at 0%!
Low balance scenario where we contribution ~$300/yr & it grows at 3%. See how quickly the basis catches up to the balance (the purple line is right at the orange line by the time she is 7). That’s the power of harvesting capital gains for your dependents.
By making these taxable transactions periodically and harvesting her capital gains, she will incrementally increase the cost basis of her investments. As her new cost basis increases, she has a lower potential tax burden in the future. The next two scenarios are a little more aggressive, but also show the power of this approach. Here’s the nominal scenario (contribute about $850/yr; grow at 7%/yr) resulting in around $50,000 of investments with little to no tax obligation at age 21:
In this scenario, the growth is high enough that she needs one year of filing single to fully catch back up. The net result is that by 21, she has a big asset with little to no tax obligation.
Finally, the high growth scenario is truly exciting. Yes, we’re contributing $1700/yr, which could be a pretty high burden for some folks. And, the funds are growing at 9% year after year. That’s high, but not unreasonable, I hope.
There it is: nearly $100,000 of assets with ~$0 of tax obligations against them. How cool is that?
By age 21, she has nearly $100,000 of investments, again with nearly $0 in tax obligation. Have a crazy cool 21st birthday? OK! Pay off a big chunk of student loans? OK! Down payment for a house? OK! Seed capital for a business? OK! It’s enough that she can do almost anything…but she cannot do nothing.
Disclaimer: While we have a passion for providing entertaining, informational, and possibly useful articles about personal finance, we’re just random people on the internet with no formal credentials or expertise. Talk to a licensed professional advisor if you need advice.
