The Power of monthly contributions and compounding

Most banks calculate accrued interest daily and credit monthly.  This means that banks take the daily balances and accrue interest on each day. The total interest calculated for the days are totaled to get your monthly interest that is deposited to your account.  This method is typically used because your balance is different each day.  If interest were to be calculated on the balance at the end of each month, the calculation wouldn’t be accurate because the balance at the end of the month is not representative of the balance in the account for the entire month.  You may have deposits and withdraws during the month, causing fluctuations in the balance throughout the month.

For simplicity, we illustrate the below table with monthly compounding at .75% annual percentage yield (APY).  Interest bearing accounts are usually quoted in APY, which is slighter higher than the annual percentage rate (APR), because APY takes into account the compounding of interest.  The calculated interest is added to the balance on which interest is calculated. Basically, you are earning interest on the interest.

As you can see below, an investment of $100 for 18 years will not amount to much.  But, if you make monthly contributions of $100 per month for 18 years, you will have a nice balance.

Year One-Time Contribution $100 monthly Contributions
1 $100.00 $1,305.64
2 $101.51 $2,520.35
3 $102.27 $3,744.20
4 $103.04 $4,977.27
5 $103.82 $6,219.61
6 $104.60 $7,471.31
7 $105.39 $8,732.42
8 $106.18 $10,003.03
9 $106.98 $11,283.19
10 $107.79 $12,573.00
11 $108.60 $13,872.50
12 $109.41 $15,181.79
13 $110.24 $16,500.93
14 $111.07 $17,830.00
15 $111.90 $19,169.08
16 $112.75 $20,518.23
17 $113.59 $21,877.53
18 $114.45 $23,247.06
18 years of savings at .75 APY, assumes monthly compounding.

Most companies offer direct deposit options in which your specified amount would be deposited to your designated bank account(s) each paycheck.  If your employer offers direct deposit options, you should take advantage of this, even if you are only able to contribute a little each paycheck.  With this feature, you can forget about that money, and you will be pleasantly surprised to see how much your balance becomes in a few months and in a few years!

 

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Children’s Savings Accounts Explained

There are many options available for children’s savings.  Within those options are the multitude of institutions that can provide those services.  Many institutions offer several types of savings accounts, so you can move between them.  We’ve categorized the types of savings into four:  (1)Treasury Bonds (2) traditional savings account (3) custodial account and (4) educational accounts.

Treasury Bonds has been the traditional American way of saving for a child.  They are a reliable, low-risk, government-backed product that should be used for long-term investment.  Bonds earns a fixed interest rate for up tot 30 years.  You can cash them in after one year. But if you cash them in before five years, you lose the last three months’ interest.  However,  after January 1, 2012, paper bonds were no longer available.  All bonds can only be purchased online through TreasuryDirect.gov.  There are two types of bonds that can typically be purchased, the EE and I series.  You can purchase in any amounts of $25 or more, up to $10,000 per calendar year.  Interest earned is taxable for federal, but not state.  However, the tax can be avoided if the money is used for higher educational.  Bonds are in the owner’s name.  So, if you buy a bond for a child, it will be in the child’s name and will be taxed at the child’s rate.  You can report the interest earned each year, or defer reporting until the bond is redeemed, which is the most common selection.

IMG_2281Traditional Savings accounts earn interest.  A few banks will allow parents to open an account under the minor’s name with the parent as joint owner for minors of any age.  Some others have an age restrictions.  Parents and children have full access to the money and can be withdrawn anytime.  There are no restrictions on the usage.  Interest between $950 and $1,900 is taxed annually at the child’s rate, and above is taxed at parent’s higher rate.

Custodial accounts, or trusts, are the Uniform Transfers to Minors Act (UTMA) and the Uniform Gifts to Minors Act (UGMA).  Both allow securities to be held in the custodian’s name for the benefit of a minor.  After the child reaches the age of maturity (18 or 21 depending on the state), the assets becomes the property of the child and the child can use them for any purpose. As such, this is an irrevocable plan.   Interest between $950 and $1,900 is taxed annually at the child’s rate, and above is taxed at parent’s higher rate.  Most states have UTMA, which allows for any kind of assets, including real estate, to be transferred to the minor.  The remaining few states still have UGMA, which limits the transfers to bank deposits, securities and insurance policies.

Educational accounts include the 529 and Coverdell Education Savings accounts. The 529 plans are tax advantaged college that allows you to set aside money for future education expenses, and the cap for contributions are set very high (over $300,000 in some states).  Contributions are not deductible from federal income tax liability, but many states provide state income tax deductions for all or part of the contributions of the donor.  While most plans allow investors from out of state, you can’t get the state income tax deduction unless you are investing in the plan of your state of residence.

There are two types of 529 plans, prepaid plans and savings plans.  Prepaid Tuition plans allow one to purchase tuition credits at today’s rates to be used in the future. Currently only a few states provide a prepaid tuition plan, and only a few offer a Guaranteed Plan (Florida, Maryland, Massachusetts, Mississippi, Virginia and Washington), while other states (Illinois, Michigan, Nevada, Pennsylvania and Texas) do not guarantee them, meaning that the terms of the agreement can be changed or terminated at anytime, as some states are currently considering.  Prepaid plans only apply to public colleges.  The College Savings plan holds investments in mutual funds.  A benefit of the 529 plan is that the principal grows tax-deferred and distributions for the beneficiary’s college costs are exempt from tax as long as the withdrawals are used for higher education.

The Education Savings Account (also known as Coverdell ESA) is used to put away funds for qualified education expenses of the beneficiary. Contributions are made on an after-tax basis, and earnings generated may not be subject to taxes if expenses are used for education.  You can use the funds for expenses for grades kindergarten through 12 as well as college. The maximum contribution limit is $2,000 per child per year.