investment strategy

What’s the Best Investment Account for a Baby?

May 4, 2022

Even before you welcome a brand-new bundle of joy into your life, you should take some time to consider that child’s financial future.

After all, life can be expensive — and it doesn’t matter whether you’re a parent, godparent, grandparent, aunt, uncle, or simply a caring friend. You’ll want to do everything you can to make sure the baby in your life grows up to enjoy the gift of financial freedom.

By investing right at the start of a child’s life, you’ll have years to build a big nest egg that grows alongside that child. The trick is finding the best investment account for the baby in your life. Fortunately, we’re here to help.

This guide explains what an investment account is, the different types of investment accounts you can set up for a baby, and the best investment account type for most families.

But before we go straight into what sort of investment account is ideal for a baby, let’s talk about what an investment account even is.

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What is an Investment Account?

In its most basic form, an investment account can be any number of investment vehicles an individual can use to buy, sell, or hold assets. Investment accounts are typically used to transfer money in transactions to brokerages and other firms that facilitate securities and deposit services.

Investment accounts are particularly useful if you’re trying to make transactions in relation to stocks, bonds, mutual funds, or exchange-traded funds (ETFs).

So, why do individuals use investment accounts?

First and foremost, investment accounts help you achieve long-term growth.

According to Goldman Sachs, the average ten-year stock market return has come in at an average of 9.2% per year over the course of the last 140 years — and the S&P 500 has done even better. Over the last decade, the S&P 500 has generated an average return of 13.6%.

Screenshot of 10-year S&P 500 returns
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Generally speaking, you’re not going to get those kinds of returns with even the best savings account. That being said, it’s also important to note investments aren’t a sure thing — your returns can vary based on market fluctuations, time horizons, taxes, fees, and more. There is an element of risk when you invest, and so an important element of investing is understanding your appetite for risk and how that stacks up against any potential reward.

Investment accounts are also popular because they enable you to create a unique portfolio that matches your own particular investment style. You can cater your assets and the way you store them to account for your investment horizon, risk appetite, and more.

Another key reason so many individuals opt for an investment account is that they tend to offer a number of unique tax benefits. Many investment account types allow you to defer the payment of personal income tax.

Other investment accounts enable you to make tax-free withdrawals under certain conditions, and you can often reduce your overall tax liabilities through IRS rules like the Kiddie Tax and the Gift Tax.

Finally, investment accounts empower you with the ability to create generational wealth. By investing now, you’ll be able to create wealth that you can pass down to the children in your life when they come of age.

What is the Best Investment Account For a Baby?

If you’re keen on building wealth for the children in your life, it’s always best to start early. Fortunately, there are a number of investment accounts that are designed specifically with babies in mind.

But each investment account has its own set of pros and cons — and what works for one family might not be ideal for yours. That’s why it’s critical to understand each investment account type and how it works before you set one up.

To help you get started, let’s walk through a few of the most popular account types.

Custodial accounts

If you’re looking for the most flexible and tax-efficient investment account for a baby, one of your best options is going to be to set up a UGMA custodial account.

A UGMA custodial account is an investment account that enables an adult to hold assets on behalf of a child until they come of age.

When you set up a custodial account, you have to appoint a child beneficiary. From that point on, every asset invested into that UGMA account becomes the legal property of that child.

But because the child isn’t old enough to make financial decisions, you serve as the account’s custodian. That means you’re responsible for managing the account until the child beneficiary reaches the “age of majority.”

The age of majority is a little bit different depending on the state, but it’s normally either age 18 or 21. When the child reaches the age of majority in their state, the custodianship ends, and the child can use those assets however they want to.

That’s how a UGMA custodial account works. But what makes it an ideal investment account for a baby?

With a UGMA account, you’re not plagued by contribution limits. That means you’re free to place as much money into a custodial account as you’d like to — and because children have such a long investment horizon, you have time to create a much bigger nest egg with a custodial account.

You’re also going to benefit from the IRS Gift Tax. This is the rule that lets you gift up to $16,000 per person per year to someone else without having to report it and pay taxes on that gift. This is what’s known as your annual gift tax exemption (or “gift tax limit”).

(You can learn more about the IRS Gift Tax in our article, “What is the Tax Free Gift Limit for 2022?”)

If a custodial account sounds like something you’re keen on pursuing, you should definitely check out EarlyBird.

Screesnhot of EarlyBird mobile view
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With EarlyBird, you’re able to set up a UGMA account for a child and choose from a range of ETF-based portfolios. Each portfolio is based on the factors that matter most to you, like your risk appetite and investment horizon — but with EarlyBird, you also get enhanced personalization.

Anyone can contribute to a child’s EarlyBird nest egg with just a few swipes. You can even include a video message to accompany your gift so that the child appreciates just how important that contribution ultimately will be to their financial future.

Unlike other custodial account providers, EarlyBird even enables you to invest in cryptocurrency for a child.

529 college savings plan

A 529 college savings plan is an education investment account that lets you invest cash or assets into a fund that can be used to pay for a child’s future college fund.

529 plans are administered by state governments, and so the precise rules and account types vary from state to state. But generally speaking, the reason most parents opt to set up a 529 plan for a baby is that it offers some attractive tax benefits that can help you pay for their college education later on.

With a 529 plan, all of the money you invest is allowed to grow free from federal income tax and state income tax. When it comes time to withdraw, you won’t need to pay taxes on the money you take out of a child’s 529 either — but only as long as those withdrawals are for a “qualified education expense.”

Illustration showing how 529 funds can be used vs custodial account funds
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This stringent rule on qualified expenses is one of the major drawbacks of the 529 plan. A lot of college expenses like new tech, off-campus accommodation, travel, and food aren’t considered qualified expenses.

It’s important to note that if you divert funds for non-qualified expenses or the child you’ve invested for chooses not to go to school and you withdraw the money, it becomes taxable income, and you’ll pay a 10% penalty. If another child in the family decides to go to college, you can transfer the funds to their account to avoid the penalty.

You should also bear in mind that some 529s have contribution limits that hinder the amount you’re able to save for a baby’s future education. That’s why a lot of parents keen on leveraging the tax benefits of a 529 plan will also opt to set up a UGMA custodial account alongside a 529 plan.

Trust funds

Another type of investment account you can set up for a baby is a trust fund. Families often use trusts to protect the total value of their estate by reducing the inheritance tax for beneficiaries.

The key benefit you can expect to gain with a trust is that you can impose any number of rules around when your beneficiary receives the assets and how they can use the funds.

But there are a few major drawbacks, too.

First and foremost, the baby you’re saving for will still likely have to pay a capital gains tax on anything they profit from within the trust. Yet more important still, trust funds are pretty complicated and expensive to set up and maintain. That’s why a lot of families tend to go for a custodial account instead.

Can I Buy Stocks in my Child’s Name?

To buy and sell stock shares, you normally need to set up a brokerage account — and brokerages won’t let you set up an account until you’re over 18 years old.

But with a custodial account, it’s possible for an adult to buy stocks on behalf of a child and hold it in the account as that child’s legal property. This enables the children in your life to benefit from stock ownership over a longer time horizon and allows their nest egg to grow larger.

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Conclusion

If you want to put your money to work and build a nest egg for the baby in your life, setting up an investment account is an absolute must.

But before you set up an investment account for a baby, it’s important that you understand the available options — and the pros and cons associated with each of them.

No two babies are alike — and so the best investment account for the baby in your life might not be the best option for the kid next door.

With a UGMA account, you’re going to benefit from flexibility and ease of use, and you’ll make your money work for the kids you love.


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