Investing our time, energy, and love in the kids in our lives is our most important task.
As parents, when it comes to our finances, one of the most powerful things we can do is to invest money for our children.
Early investments have longer to grow and can snowball over time. Even a small investment made for a newborn child can grow into a substantial amount of money by the time they reach adulthood.
But what is the best way to invest money for a child? This comprehensive guide breaks down how, where, and why to invest money for children.
The Importance of Early Investing
Investing as early as possible is incredibly beneficial, thanks to the effects of compound interest.
When you invest money, your investments start to earn money — in the form of dividends (interest) and stock price growth.
And these earnings compound, which means that your profits start earning profits of their own. This creates a snowball effect, which allows your investments to grow faster and faster over time.
For example, if you invest $1,000 once in an investment earning around 5% per year, you’ll earn $50 in interest in the first year, $52.50 in the second year, $55.13 in the third year, and so on.
You can further accelerate wealth building by investing regularly.
Examples of investment growth
The below examples assume 7% average returns.
Investing $1,000 one time at a child’s birth would grow into:
- $3,379.93 by age 18
- $14,974.46 by age 40
- $81,272.86 by age 65
Again, this example is for a one-time investment. The results are even more impressive with regular investments.
Investing $100 per month starting at a child’s birth would grow into:
- $41,136.83 by age 18
- $241,059.58 by age 40
- $1,384,233.48 by age 65
Use a compound interest calculator to see how much your investments could grow.
Best Way to Invest Money For a Child
There are two main aspects to investing for children:
- Where to invest, and what type of account to use
- What to invest in (stocks, bonds, etc.)
In each category, there are many, many choices. This can feel overwhelming for parents and loved ones, particularly those who don’t have much investing experience themselves.
The good news is that investing doesn’t have to be complicated.
Here’s a one-sentence explanation of the best way to invest money for a kid:
Open a custodial investment account, buy low-cost stock market index funds, and set up repeating investments monthly.
Want something even simpler? Open an account with EarlyBird.
EarlyBird makes it simple to set up a custodial investment account and automatically invest in a diversified portfolio of investments. Better yet, the EarlyBird app also makes it simple for loved ones and friends to collectively invest in the child’s account — a grandparent, uncle, or aunt can chip into their account with a single click.
Let’s break down investing for children and explore the best investment account to use and the best investment to buy in more detail.
Best Investment Account to Use: UGMA Custodial Account
Investing starts with opening an account that allows you to invest.
In most cases, this will be some sort of brokerage account. An account with a brokerage firm will allow you to invest in stocks, ETFs, mutual funds, bonds, and more.
However, children usually can’t open a brokerage account or buy stocks until they become an adult.
Fortunately, there’s a workaround: Custodial investment accounts.
Custodial investment accounts have a “custodian” (the adult) and a “beneficiary” (the child). The custodian opens the account in the child’s name, and the child gains control once they become a legal adult (18 in most states; 21 in a few).
The custodian is responsible for managing the account, selecting investments, and contributing money. The beneficiary technically owns the account the whole time, but they don’t directly control it until they become an adult.
There are several types of custodial accounts, including:
- College savings accounts like the 529 account
- Custodial retirement accounts like the custodial Roth IRA
- General-purpose custodial accounts like the UGMA or UTMA account
In most cases, UGMA/UTMA custodial accounts are the optimal choice. These accounts provide the most versatility and are often the simplest to set up and start using.
UGMA stands for Uniform Gifts to Minors Act, while UTMA stands for Uniform Transfers to Minors Act.
The accounts are very similar. The UGMA account is best suited for traditional investments like stocks and bonds, while the UTMA account can support physical assets like real estate or precious metals. UGMA accounts are more widely available and are generally the simplest option.
With a UGMA or UTMA custodial investment account, the funds can be used for anything. Once the child gains control of the account, they can use the money for college, a down payment, a gap-year trip, or any other purpose.
Other accounts are restrictive with what the money can be used for. Custodial retirement accounts require the funds to be used at retirement age (and there may be penalties for early withdrawal). And 529s require funds to be used for college tuition.
If you’re not sure what the child will need the money for, UGMA custodial accounts are the way to go.
The EarlyBird investment app is the simplest way to open a UGMA account for a minor. Get started today.
Other investment account options
UGMA accounts are the most versatile, but there are other options, like the college savings plans and retirement accounts we mentioned earlier.
529 plans: 529 savings plans are a type of college savings plan that is sponsored by state governments. They offer tax perks when the funds are used for college tuition and other qualifying educational expenses. Basically, investments can grow tax-free while in the account, and no taxes are owed upon withdrawal — as long as the funds are used for eligible expenses.
Coverdell ESAs: The Coverdell Education Savings Account (ESA) is another type of college savings account. It’s somewhat similar to a 529, but it has a much lower contribution limit of up to $2,000 per year. Investments can grow and be withdrawn tax-free, as long as they’re used for qualifying educational purposes.
Custodial Roth IRAs: The custodial Roth IRA is a type of retirement account. It allows funds to be invested and grow tax-free, and withdrawals are also tax-free once the beneficiary reaches retirement age. However, only earned income can be contributed to a Roth IRA. This means that the child must have earned income from a job or business in order to contribute to a Roth (allowance does not count).
Regardless of which account type you use, be sure to read up on custodial account tax rules.
Best Investment To Buy: Stock Market Index Funds
Once you have an account, the next step is to actually start investing. And again, there are dozens of options here.
Deciding what to invest in depends on several factors:
- The time horizon: How long until the child will need the money from the investment? Longer time horizons can generally afford more risk in the investment strategy.
- The risk tolerance: Are you comfortable with higher-risk, higher-reward investments like stocks or cryptocurrency? Or would you prefer lower returns from safer investments, like bonds?
- The involvement level: Do you want to actively select stocks to invest in or automate as much as possible? Most investors will be best off using passive index fund investing (more on this below).
In most cases, the best investment for kids is stocks.
Historically, stocks have offered the best long-term returns. Over the last century, the US stock market has returned approximately 10% per year. Long-term government bonds (a safer investment) have returned 5–6% per year.
That might not seem like a huge difference, but over the long term, it is very substantial.
- $100 per month invested for 30 years at 10% returns would result in $199,137.77.
- $100 per month invested for 30 years at 5% returns would result in $80,158.81.
Of course, these are just hypothetical returns based on historical performance. Your actual investment performance may vary based on a variety of factors, including (but not limited to) market fluctuations, time horizon, taxes, and fees.
If stocks are the best investment, how do you actually invest in stocks? Should you pick individual stocks?
The simplest approach is to buy low-cost stock market index funds. Index funds buy dozens or hundreds of different stocks and allow investors to buy into the fund all at once. They are available as mutual funds or exchange-traded funds (ETFs).
For example, S&P 500 index funds buy stock in all 500 companies included in the S&P 500 index (the 500 largest publicly-traded companies in America).
By buying an S&P 500 index fund, you can own very small slices of 500 large companies. There’s no need to pick the right stock or actively trade. Index funds are a set-it-and-forget-it approach.
And they work. In fact, legendary investor Warren Buffet recommends that everyone invest the bulk of their assets in index funds. Many financial advisors and experts agree.
Diversification in your investment portfolio
You don’t have to invest only in stocks or only in bonds. In fact, it’s wise to invest in a variety of assets to “spread out your bets.” This is the basic principle of diversification.
You can diversify within an asset class (like buying an index fund or mutual funds instead of individual stocks) or between asset classes (like buying stocks and bonds).
The simplest way to build a diversified investment portfolio for a child is to use EarlyBird. When you sign up for EarlyBird, you’ll be asked a series of questions based on your investing goals, desired risk level, and more.
Then, you’ll be recommended a specific diversified investment portfolio built up of low-cost investments. Simply select the desired portfolio and start investing today. No investment experience is required.
Other investment options
Stocks offer the best long-term returns, but there are many other investment options to consider.
Bonds: Bonds are like I-O-U’s. Companies and governments who wish to raise money can sell bonds, which investors can purchase. The issuing company/government promises to pay back the principal amount after a certain period of time with interest along the way. You can buy individual bonds or bond index funds. Bonds can be low-risk to high-risk, depending on the issuing company/government.
Certificates of deposit: Certificates of deposit (CDs) are available from banks and credit unions. They are like a savings account that locks your money up for a certain period of time in exchange for a slightly higher interest rate. CDs are a low-risk, low-reward investment.
Real estate: Real estate can be invested in via actual real estate (houses or apartments) or through real estate investment trusts (REITs), which are like index funds for real estate. Real estate is a moderate-risk, moderate-reward investment.
Cryptocurrency: Cryptocurrency is a digital currency. Popular options include Bitcoin (BTC) and Ethereum (ETH).
Other assets: Other assets include precious metals, collectibles, artwork, and more.
In most cases, the best way to invest money for a child is to open a custodial account and buy low-cost stock market index funds.
This strategy provides strong potential for long-term investment returns. And when the child gains access to the account (at 18 or 21, depending on the state), they can use the funds for any purpose they choose.
EarlyBird is the simplest way to open a custodial UGMA account and get started with investing.
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.