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WHEN MY TWO CHILDREN were ages nine and five, I opened Vanguard Group variable annuities for them. No, variable annuities aren’t my favorite investment. Far from it. Indeed, I don’t think they’re anybody’s favorite investment vehicle, unless you happen to be an insurance agent angling for a big commission.
Still, tax-deferred annuities differ from other retirement accounts in one crucial way: You don’t need earned income to fund the account. That means it’s possible to open a tax-deferred annuity for a toddler, thereby setting the kid up for decades of investment compounding.
Children may not have a whole lot of money, unless their parents pitch in, but they have something even more valuable, which is time. The accounts I opened for Hannah and Henry, now both in their 30s, are today comfortably into six figures. Hannah was sufficiently impressed by her account’s growth that she asked me to open variable annuities for her two kids—my grandchildren—who are ages four and one.
Since I set up the accounts for Hannah and Henry, Vanguard has unloaded its variable annuity business to Transamerica. Still, at 0.27% of assets a year, the variable annuity’s contract charge remains reasonable, the funds offered within the variable annuity are low-cost Vanguard offerings, and there’s no commission to buy or sell. But I can’t shake the worry that all this could change now that Transamerica is the administrator.
That’s why, for my two grandkids, I opted instead for Fidelity Investments’ variable annuity. The Fidelity Personal Retirement Annuity’s contract charge is 0.25% a year and, if you pick carefully, the fund expenses can also be fairly low. I settled on a 50-50 split between the total U.S. stock market index fund, which costs 0.11% a year, and the international index fund, which charges 0.16%. The accounts are set up as custodial accounts, with my daughter as the custodian. Custodial accounts count heavily against families in the financial-aid formulas, but I doubt my two grandchildren will be eligible for aid, given their parents’ income.
Is it really worth buying a variable annuity—even a low-cost one—to give a child an early start on a lifetime of investing? Suppose my grandchildren own their variable annuities for 60 years, which is likely because the 10% penalty on withdrawals before age 59½ creates a healthy incentive to leave the money untouched. Let’s also suppose their accounts earn an after-inflation 6.6% a year. This assumes the stock market delivers 7% a year, but investment costs snag 0.4 percentage point of that annual return.
At 6.6% a year, the $10,000 that I invested for each grandkid will be worth an after-inflation $463,000 after 60 years. What if I hadn’t bought the variable annuities, and instead they started on retirement saving in their early 20s? At that juncture, they’d be looking at perhaps 40 years of compounding. At 6.6% a year, $10,000 would grow to some $129,000, or 72% less than the $463,000 they’d have with the earlier start.
You could quibble with these numbers, especially the return assumption. Still, it’s clear that snagging an extra 20 years of compounding makes a huge difference.
When I was investing for Hannah and Henry, I didn’t just open variable annuities for them. I also set up taxable accounts where I invested money for a future house down payment. Later, when they had some earned income, I opened Roth IRAs on their behalf.
I would, of course, love to open Roth IRAs for my grandkids. Think about it: decades of stock-market compounding, all of it tax-free. It’s a gift I’d love to see given to every young person—and perhaps the savings initiative launched last week will help to make that happen.
Unfortunately, at ages four and one, my grandchildren don’t have the earned income needed to qualify for a Roth. When they do, I hope their parents will remember this article—and open Roth IRAs on their behalf.
Jonathan Clements is the founder and editor of HumbleDollar. Follow him on X @ClementsMoney and on Facebook, and check out his earlier posts.
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Notice how well liked your articles are liked! and they should be as they are very informative. I am not an annuity type, but buying a stock fund, and being able to start a ROTH IRA, is surely a wonderful thing for any young person. All those extra years of compounding really do a nice job for any investment. And just one share of some popular stock, could turn into a BIG savings account. If I bought one share of McDonalds, recommended by many at age 18 in 1965, it would be worth well over $200,000 today!
I am all for keeping it in the family, and getting as much stretch as you can to give children and grandchildren a start in this world. Now that funds left over in a 529 after graduation can be converted to Roth for the same beneficiary, this is another pathway to achieve this idea while at the same time covering most higher education expenses.
My first two grandchildren have just graduated from universities debt free through Utah 529 accounts I opened when they were very young. My latest grandchild has his Utah 529 as well.
I like Utah because it has a very low expense ratio of .113% for assets in their plans and a slightly higher one for Target Date choices. And, the investments themselves are also very low cost index funds. Because I live in a no income tax state, there is no advantage to me to use it’s 529 plan which is not as efficient as Utah.
I like the idea of opening a 529 plan for a grandchild to cover some college expenses and converting the rest to a Roth IRA. It’s important to name one or more successor owners since the plan could take twenty years to execute (529 plan held for 15 years and another 5+ to convert to a Roth IRA based on earned income).
https://www.fidelity.com/learning-center/personal-finance/college-planning/grandparents-can-help-fund-college
Jonathan, Are you sure paying ordinary income tax rates on annuity withdrawls and the extra .25% annuity charge ( on top of fund expenses) is better than just opening a taxable brokerage account with really low cost index funds and capital gai tax treatment isn’t a better choice?
I think you’ll find the extra decades of tax deferral offset the higher tax rate — plus we have no idea what the tax code will look like six decades down the road — but you could no doubt cook up a scenario where the taxable account comes out ahead (e.g. no dividends paid, no trading ever, no capital-gains distributions ever). But maybe more important, there’s no 10% early withdrawal penalty on a taxable account to deter the kids or grandkids from cashing out the account early on.
When each of my grandchildren was born I opened a separate Roth in my name but each as the beneficiary. My goal is to move the money over to a Roth in their name as soon as they have any earned income until it is all migrated. And if I pass they have the stretch period to do the same. My kids understand the plan and know it is for retirement, but if my wishes go unheeded after I’m gone I won’t be around to complain.
Interesting idea Tom. I assume you are beyond age 59.5. I hope the kids honor your wishes. It’s truly a great gift.
I just read a version of this story in your latest book. As Edmund says below, I wish I had financial insight and understanding back when my kids were very young.
There’s a huge difference between the Fidelity VA and the ones sold by insurance companies, whose fees can end up around 3% with all the bells and whistles.
The Fidelity VA may also be suitable for the loss adverse adult who intends to leave a legacy, and can’t sleep with the thought of losing any money. My father was a product of the depression and wanted nothing to do with the market, he was also sick with prostate cancer. He and mom sold the house and moved into my place. This was early 2004 and the market was right for investing. Dad knew his time was short, his only financial concern was to not lose any money. He liked the insurance aspect of the VA; upon his death my mom would receive the greater of the initial investment or its appreciated value. When dad passed in August of that year, the VA had grown by 15%, a very nice 6 month profit with absolutely no risk to the principal.
I’m sure many HD readers are familiar with your friend and colleague, Bill Bernstein, and his writing about “Demographic Roulette”. It seems to me the best response is to begin investing as early in life as possible. Thanks for suggesting some strategies.
Likewise, the Stretch IRA concept was glorious until the congress critters destroyed it.
Jonathan, I believe in what you are doing for your grandchildren and for many others with the savings initiative. Engaging youngsters in saving is a start to paving their future paths.
My financial journey began with a passbook savings account, opened by my parents a week after my birth and funded with a $10 gift received on my behalf. The account grew with another $15 gift soon thereafter. I still have the passbook. My father asked the bank to record earned interest semi-annually (18 cents on Dec. 31, 1958, recorded in ink by a teller). Eventually as I grew older and could understand more, he went to the bank quarterly and showed me each entry. I recall being amazed that someone was paying me. “The future” seemed abstract at the time but nonetheless magical.
I have fond memories of going to the bank as a teenager with my latest deposit, handing over my savings book, and hearing the glorious clatter of keys as the teller added both the deposit and my most recent interest earnings.
I wish I’d been as savvy when my daughter was toddler-age. There is a taxable account ear-marked for young-adult expenses, and another that she funds with her spare money. I have friends who treat their kids and grandkids to various expensive leisure items and experiences, and I know they have their value. But I can’t help but think of the long-term payoff of balancing those types of gifts with a thoughtful donation of a more enduring nature.