When you’re trying to build enough wealth to pass on to the next generation, you’ve got to make your money work as hard as it possibly can.
That means you can’t afford to let cash stack up in an ordinary savings account and collect dust.
If you want to create a nest egg big enough to give the kids you love some financial freedom as they get older, you should consider investing. But that’ll require setting up a kids investment account on their behalf.
This guide explains why you should start investing for the kids you love today, what a kids investment account is, different types of investment accounts for children, and what the best investment plan for a child is.
Why Should You Start Investing For Kids?
Everybody wants the children they love to grow up free from financial burdens. We want them to be able to make bold choices and pursue their dreams without having to stress about money all the time.
But the sad truth is that most adults simply aren’t saving for the future.
According to researchers at FINRA, 19% of Americans regularly spend more than their household income. Meanwhile, 46% of all those adults surveyed say they don’t even have a rainy day fund. That leaves many of us with little (or nothing) to pass on to future generations.
Translation: if you want to truly build a solid nest egg and make your money work harder for the children you love, you should consider setting up an investment account.
Why set up a kids investment account?
According to the behemoth investment bank Goldman Sachs, the average ten-year stock market return grows by 9.2% every year. It’s consistent, too. This average has been alive and well for the last 140 years.
Believe it or not, the S&P 500 index does even better than those averages. Over the last decade, the S&P 500 has generated average returns of 13.6% per year.
If you try to compare those nice returns against cash, there isn’t going to be a contest. After all, you’re probably not going to find any savings vehicles or money market accounts capable of offering investors that sort of compound interest rate over time.
Similarly, with cash, there’s always the risk that you end up getting outstripped by inflation.
For example, if you just stockpile thousands of dollars in a bank account waiting for a rainy day, currency inflation rates mean that cash is going to lose value over time.
But if you choose to invest that money in an asset that rises in value over time, it won’t matter that the spending power of cash has decreased — your investment will be worth more money, anyway.
Simply put: if you want to maximize returns for a kid, investing is the way to go.
You shouldn’t use an ordinary bank account to invest in a child’s financial future. That’s where investment accounts come in.
What is a Kids Investment Account?
An investment account is a common financial vehicle that allows you to hold both cash and securities like individual stocks, dividend stocks, bonds, exchange-traded fund (ETF) shares, and mutual fund shares.
Some investment accounts allow you to deposit cash into the account. You’ll then be able to pick and choose how that cash is invested in securities on your behalf.
Most investment account providers do this by offering clients a set of pre-built investment portfolios for you to choose from.
These portfolios typically differ by risk level and asset mix — which is perfect if you’re looking for a single investment that gives you a wide investment exposure with relatively low risk levels.
There are other types of investment accounts, too. Some accounts are designed to let you store a wider range of assets — rather than investing cash in a ready-made portfolio, you’ll get to buy and deposit your own assets (like a brokerage account). That could mean stock shares, cryptocurrencies, or other asset classes.
You’ll also run into quite a few accounts that offer both investment options.
But that’s how adult investment accounts work — a kids investment account is slightly different.
Children must typically be over 18 (or in some cases 21) to open their own investment account.
That’s because the age of majority in most states is either 18 or 21. This is the age at which adults are legally able to enter into contracts and make their own financial decisions.
Until a child reaches that age, the only way for a kid to own investments is for an adult to set up a custodial investment account on their behalf.
It then generally falls upon the adult to manage the account and its assets as the account’s custodian until the child reaches a certain age or meets a particular milestone.
What Are the Different Types of Kids Investment Accounts?
There are many different reasons to invest for kids — which is why there are several unique kids investment account types that are all designed to do slightly different things.
To give you an idea, we’ll quickly break down the basics of some of the most popular kids investment accounts.
One of the most flexible investment tools out there is definitely the custodial account.
A custodial account is a dynamic investment vehicle that lets you hold various assets for a child beneficiary until they reach a certain age. You'll also sometimes hear people refer to a custodian account as a "custodial brokerage account."
When you hear people talk about custodial accounts, they’re going to be referring to one of two account types: a Uniform Gifts to Minors Act (UGMA) custodial account or a Uniform Transfers to Minors Act (UTMA) custodial account.
Both UGMA accounts and UTMA accounts get their names from the legislation that created them — and both custodial account types work basically the same in principle.
If an adult sets up a custodial account, they must name a child beneficiary. From the moment the account is set up, everything in that account is the legal property of the child beneficiary.
But because the child beneficiary is too young to make financial decisions on their own, it’s the adult who’s responsible for managing the assets in the custodial account on that child’s behalf. This makes the named adult the account’s “custodian.”
As the custodian, the adult must continue to manage and make decisions about the custodial account until the child reaches the age of majority. As we’ve already mentioned, in most states, the age of majority is either 18 or 21.
After the child beneficiary hits the age of majority, management over the assets in that account passes on to them.
That being said, there are a couple of key distinctions between UTMA and UGMA accounts you should be aware of.
The first difference is in the assets each account type can hold.
UGMA accounts are meant to hold financial assets like stocks, bonds, exchange-traded fund (ETF) shares, and mutual fund shares. By contrast, UTMA accounts can also hold less common assets like real estate deeds, fine art, and intellectual property.
Because most families don’t have lots of fine art or patents sitting around, a UGMA offers a wide enough asset mix.
The other key difference is that you can’t set up a UTMA account in all 50 U.S. states. That’s because the UTMA account legislation wasn’t ratified by every single state. On the flip side, you’re able to set up a UGMA custodial account in every state.
That’s why most families go for a UGMA account.
Whether you choose a UGMA or UTMA account, it’s important to note there’s a tax advantage with a custodial account.
Because the child beneficiary is the legal owner of everything in that account, any unearned income the assets generate (up to a certain point) is taxed at the child’s rate instead of the custodian’s higher adult rate.
UGMA accounts also offer a lot of flexibility in terms of withdrawal rules.
Unlike other kids investment accounts, beneficiaries can use the assets in whatever way they see fit — and the custodian can also make account withdrawals on the beneficiary’s behalf as long as it’s for the child’s benefit.
Another popular kids investment account is a 529 college savings plan.
A 529 plan is a pretty straightforward investment account that allows adults to invest money in a child’s future education expenses. Parents, grandparents, guardians, and other adults can typically set up a 529 plan for a child.
Each state is in charge of its own 520 plans — so the rules and account options vary from state to state.
That being said, all 529 plans have a few basic elements in common.
When you set up a 529 plan, you deposit cash into the account. Your plan provider will then typically invest that money on the child’s behalf in one of several low-risk investment portfolios.
The contributions you make to a 529 plan aren’t going to be tax-deductible, but all of the investment income is allowed to grow tax-free.
That means you won’t get taxed on any of the money you withdraw from the account — but only as long as you’re using that cash for a “qualified” education expense.
It’s worth noting 529 providers typically have fairly rigid rules on what counts as a qualified education expense. For example, things like off-campus accommodation, a new college laptop, or a bus pass aren’t normally going to count as a qualified expense.
That’s why a lot of parents decide to set up other investment accounts (like a UGMA custodial account) alongside a 529 plan.
Custodial Roth IRA
A Roth individual retirement account (IRA) is an investment account that lets you deposit various assets into a holding account. Everything in that account then grows tax-free — but only if you wait until you’ve hit retirement to withdraw the cash.
If you try to take money out of a Roth IRA before you’re retired, the IRS will likely tax you on those withdrawals. But again, kids under 18 can’t set up a Roth IRA. If you’re keen on setting up a retirement investment account for a child you love, you’ll need to open a custodial Roth IRA.
A custodial Roth IRA works pretty much the same way as a UGMA custodial brokerage account.
As the adult, you manage the custodial IRA assets on behalf of a child beneficiary. Once that child reaches the age of majority in their state, the account needs to be handed over to the (now grown-up) beneficiary’s control.
In practice, that normally means the account type is transferred from a custodial Roth IRA to a standard Roth IRA.
Apart from the rigid withdrawal rule, the major drawback of a custodial Roth IRA is that it has low contribution limits. Contributions are capped at $6,000 per year or equal to annual earned income — whichever is lower.
It’s also important to note that this income rule applies to how much money the child beneficiary makes (not you).
Translation: you can only deposit money equal to what the child has earned. You’re not supposed to supplement that account with your own income.
What is the Best Investment Plan for a Child?
No two children are alike. Because of this, the ideal investment plan for one kid won’t always be the same for another.
To know what the best investment account is for the kids in your life, you’ll need to consider a range of factors, including:
- What is your appetite for risk?
- How much do you want to invest?
- What types of assets do you want to invest in?
- When and how do you want the kid to be able to use the investments?
You should also think about how setting up a kids investment account will impact your tax burden.
But if you’re looking for an option with flexibility and tax benefits, one of the best kids investment accounts is the UGMA custodial account.
Not only does the UGMA offer the child freedom in terms of how they ultimately use their own funds, but it also allows you to save and invest as much as you’d like without having to worry about low contribution limits.
You can also contribute up to $15,000 per child per year to a custodial account free of gift-tax consequences — which means you can invest a healthy amount into a kids investment account each year to help them build a solid nest egg for the future.
So, there you have it: if you want to invest in a child’s future, one of the best ways to do it is by setting up a kids investment account.
There are a number of kids investment account types out there. But if you’re looking for an account with flexibility, tax benefits, and the ability to choose for yourself what sort of assets you’ll be investing in, your best option is probably going to be a UGMA custodial account.
Ready to start investing? Download EarlyBird today and make your money work harder for the kids you love.