One of the most powerful ways to build wealth is time on the market. As a parent, you have the great opportunity to give your children a financial gift by setting up an investment for them or helping them with investment strategies.
An early investment portfolio can become a transformative investment. Assuming the 10% average long-term return of the U.S. stock market, a one-time investment of $1,000 for a newborn baby could grow to $490,370 by the time that child reaches retirement age. (These numbers are based on the historical performance of the U.S. stock market, your results may vary based on market fluctuations, time horizon, taxes, fees, and other factors.)
It’s never too early to start investing. Whether it’s to save up for a college education, prepare for future retirement, or build passive income, you can already take steps to make investments for your child.
This guide will explain how you and your children can make investments, save for retirement, and prepare for college expenses.
Investing for Kids with Custodial Accounts
Under most circumstances, children can start buying stocks at age 18. The law requires most stock brokerages to open investment accounts only for individuals age 18 and over. This rule also applies to other investment vehicles, such as mutual funds, real estate, and cryptocurrencies.
Fortunately, you have a legal workaround. Under the Uniform Gift to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA), you can open a custodial account for your child. A custodial account is a type of investment vehicle that allows you to make investments and save for your child.
The custodial account remains in your control until your child turns 18 or 21, depending on the state. Upon reaching age 18 or 21, the child gains full access to the custodial account.
A major benefit of custodial accounts is their flexibility for investment objectives and contributions.
- Flexibility for investment objectives: A custodial account isn’t limited to “qualified expenses.” The money in a custodial account can be for retirement savings, college expenses, or any other type of expense.
- Flexibility of contributions: Besides the child’s parent, any adult can make financial gifts or make contributions to the account. Also, a parent can contribute money for the child.
What are the types of custodial accounts?
The two types of custodial accounts are named after the federal laws that created them. There’s the Uniform Gifts to Minors Act (UGMA) custodial account and the Uniform Transfers to Minors Act (UTMA) custodial account.
A UGMA custodial account allows you to deposit money and purchase most common types of investments, including stocks, bonds, mutual funds, and annuities.
A UTMA custodial account allows you to make the same investments as those in a UGMA custodial account and also in alternative assets. Examples of alternative assets include real estate, collectibles, jewelry, and intellectual property (e.g., patents, copyrights, trademarks).
What are the differences between UGMA and UTMA custodial accounts?
One difference between UGMA and UTMA accounts is the type of investments that people can make with the account. Typically, UTMA accounts provide you with a wider range of investment vehicles to choose from than UGMA accounts. Keep in mind that the financial company running the account may set restrictions on eligible investments.
Another difference is that all states allow people to open a UGMA account for their child. Most states give their residents the option to choose between a UGMA or UTMA account. However, residents of Vermont and South Carolina can only open a UGMA account for their children.
What are the taxes on custodial accounts?
The applicable tax rate on custodial accounts follows the IRS’ “kiddie tax” rule:
- The first $1,100 of a child’s capital gains receives no tax at all.
- The next $1,100 of a child’s capital gains are charged at the child’s tax rate.
- Capital gains above $2,200 are taxed at the adult custodian’s tax rate.
Keep in mind that your child’s income from any type of work isn’t considered for capital gains income calculations.
The kiddie tax rule only applies to children younger than 19 and full-time students younger than 24 who are claimed as dependents on their parent’s tax return.
What is an appropriate investment mix for children?
A custodial account is a great learning opportunity for young investors to gain first-hand exposure to investing fundamentals. An appropriate investment mix for children should focus on stocks due to the long-term holding period of custodial accounts.
The first lesson is about creating a diversified portfolio. It’s important to teach children that there’s no merit in reckless investments. To minimize investment risk, you can point them to a low-cost index fund or exchange-traded fund that tracks a collection of stocks like the S&P 500.
The second lesson is to make periodic contributions. Letting your child choose individual stocks may be helpful in creating this habit. Give them the chance to do their “due diligence” on a company to back up their choice of an individual stock or mutual fund. This way, they’ll feel they are part of the decision-making process and have a greater chance of sticking to periodic contributions.
Using Investments to Save for College
In 2021-2022, the average annual tuition cost was $43,775 at private universities and $28,238 for out-of-state students at public colleges. Given the rising trend of college costs, your investment strategy should include starting a college fund.
Here are three key education savings investment options to consider: 529 plans, Coverdell ESA accounts, and UGMA accounts.
A 529 plan is a commonly used tax-advantaged savings account for education expenses. Unlike contributions to custodial accounts, contributions to a 529 plan are deferred until distribution. If the distribution (money withdrawn from the 529 plan) goes toward a qualified education expense, then the money is tax-free.
Unlike UGMA accounts that are unlimited, 529 plans have annual contribution limits, but the good thing is that these limits are quite high. Since 529 plans are state-sponsored, states set contribution limits. In 2022, 529 plan contribution limits range from $235,000 to $529,000, depending on the state.
How can my child use a 529 plan?
While the state sponsors the plan, it doesn’t determine the school that your child attends. Your child can attend any qualified school in or out of the sponsoring state. One exception is a specific 529 plan called a prepaid plan. With a 529 prepaid plan, you’re locking in the current cost of attending specific in-state public colleges.
What happens to the 529 plan money if my child doesn’t go to college?
If your child were to decide that college isn’t a worthwhile option, then it'd make more financial sense to transfer the 529 plan to an eligible relative than to spend the money.
Money spent on nonqualifed expenses is subject to applicable income taxes plus an additional 10% penalty from the IRS. Instead, you or your child as an adult can transfer the 529 plan to an eligible family member or relative, avoiding both taxes and the penalty.
Coverdell Education Savings Account (ESA) accounts
A Coverdell ESA account is another type of tax-advantaged savings account for education expenses. While the money you put into a Coverdell ESA can’t be deducted, contributions grow tax-free until withdrawal.
What are the similarities and differences between 529 plans and Coverdell ESA accounts?
The two education savings accounts are similar in that:
- Withdrawals are free of taxes when used on qualified education expenses.
- Typically, early withdrawals and use on non-qualified expenses are subject to penalties and applicable income taxes.
- Most 529 plans and Coverdell ESA accounts have fees
Some of the differences between 529 plans and Coverdell ESA accounts include:
- Income limit: In 2022, only individuals with an adjusted gross income (AGI) under $110,000 and couples filing jointly with an AGI under $220,000 can contribute to a Coverdell ESA account. A 529 plan has no such income contribution rules.
- Contribution limits: Up to $2,000 per child per year can go into a Coverdell ESA account. Contribution limits to 529 plans range from $235,000 to $529,000, depending on the state.
UGMA custodial accounts
All residents of any of the 50 states can open a UGMA custodial account and invest in stocks and other common investment vehicles to save money for college costs.
The UGMA custodial account stands out from all education savings investment options in that your child won’t be limited to qualified education expenses. It’s not unusual that your child will run into nonqualified expenses, such as college application and testing fees, transportation costs, and required health insurance costs.
One alternative is to save for your child's college expenses and cover qualified education expenses with a 529 plan and/or Coverdell ESA account and nonqualified expenses with a UGMA account.
But it is up to you to determine which accounts fit best into your investment strategy based on your goals, family situation, and other factors like tax advantages or the flexible use of funds.
Preparing Kids for Retirement with Investments
Eventually, your kid will start earning money. Whether it’s from a summer job, a small entrepreneurial venture, or a cash award from a competition your child’s money can be an opportunity to start putting away for retirement.
When your child earns income, a custodial individual retirement account (custodial IRA) is an investment vehicle that you can use to save for his or her financial future.
Why does a custodial ROTH IRA make sense for children?
While both a custodial traditional and ROTH IRA can help your child save for retirement, a custodial ROTH IRA makes more financial sense.
The main reason is that your current child’s tax rate is most likely to be the lowest in his or her lifetime. So instead of deferring taxes until retirement, it makes more financial sense to pay for taxes upfront at a lower rate. Then, let the money grow tax-free and make withdrawals tax-free in retirement.
How is a custodial ROTH IRA different from a UGMA custodial account?
A key difference is the maximum contribution per year. In 2022, your child's maximum contribution is $6,000 of his or her earnings. In the same year, the contribution limit to a UGMA custodial account is higher ($16,000 for a single filer or $32,000 for a married joint filer).
One of the best ways to help your kids is to teach them about investments as early as possible. By adding several years to the holding period of your children’s investments, you’ll increase their chances of reaching their target goals.
There are many types of accounts that can help you make investments and provide benefits for children. For example, UGMA custodial accounts are popular options that don’t have income requirements and can be used for a variety of uses.
You can supplement UGMAs with other investment accounts for specific purposes. Some examples are custodial ROTH IRAs for retirement savings and 529 plans for college savings.
This page contains general information and does not contain financial advice. All investments involve risk. Any hypothetical performance shown is for illustrative purposes only. Actual investment performance may be different for many reasons, including, but not limited to, market fluctuations, time horizon, taxes, and fees. Please consult a qualified financial advisor and/or tax professional for investment guidance.