Understanding the Stock Market for Kids

May 20, 2021
financial literacy

If you want to build a big nest egg for a child’s future, the stock market is an incredible place to make it happen.

Over the course of the last decade, the S&P 500 index has generated an annual average return of 13.6%. That’s a pretty attractive return on investment (ROI) if you’re getting involved in the stock market for kids.

If you start investing now, you could generate major returns by the time that little bundle of joy grows up. But it’s important to bear in mind that the stock market can be a tricky egg to crack, and it’s not without risks.

That’s why you’ve got to do your research and teach the kids in your life about the stock market early.

In this guide, we’ll explain the rules around how kids can invest in stocks, the investment vehicles you can use to invest in stocks for kids, and how a UGMA custodial account with EarlyBird can help supercharge a child’s future.

Can a Kid Invest in the Stock Market?

One of the biggest questions adults may have when taking a look at the stock market is whether the children they love are allowed to invest in it as well. After all, investing in stocks is a fantastic way to teach a child financial literacy and start investing in their future.

Unfortunately, the answer to that question isn’t super straightforward.

Most adults who trade stocks use an account they’ve set up with a stockbroker to buy and trade securities — whether it’s a traditional broker or a sleek new trading app. And, strictly speaking, you’ve got to be 18 years old to open a brokerage account in most states. 

That means kids can’t directly buy and sell stocks until they hit the age of 18. 

But don’t let that discourage you if you’re really passionate about getting the kids in your life involved in the stock market from an early age.

There are several popular options that are worth exploring if you want to help the children you love invest in stocks. To help you get started, we’ll quickly break down three of the most common ways kids invest in the stock market.

Custodial accounts

If you want to introduce kids to the stock market, one of the best options you can go for is to set up a custodial account.

A custodial account is an investment vehicle that enables an adult to open an investment account for a child who is under 18. That adult can be a parent, godparent, grandparent, aunt, uncle, or even a family friend.

When an adult sets up a custodial account for a child, that adult becomes the account’s “custodian.” 

This means they’re responsible for managing the money and investments held in the account. Still, it’s important to bear in mind that nothing in that account is the custodian’s legal property.

Each account has a named child beneficiary, and the assets belong to them. When that child reaches the “age of majority” in their state, the custodianship ends. Everything in the account then passes onto the child.

In most states, that age is either 18 or 21, depending on the type of custodial account you go for.

There are two main custodial account types: UGMA accounts and UTMA accounts.

A Uniform Gifts to Minors Act (UGMA) account can be used to hold a broad range of financial asset classes. This includes stock shares, bonds, exchange-traded funds (ETFs), mutual fund shares, and more.

A Uniform Transfers to Minors Act (UTMA) account is also an option. It can hold less tangible assets like patents to inventions or fine art. But since a lot of families don’t have those kinds of assets and UTMAs aren’t permitted in all 50 U.S. states, most people just choose a UGMA instead.

One of the big advantages of setting up a custodial account, such as an UGMA account, centers around taxes. 

Because stock market investments in the account are the legal property of the child, any unearned income on the account up to a certain amount is taxed at the child’s rate.

That means the first $2,200 worth of interest the child’s account generates each year will be taxed at a lower rate — but it’s important to bear in mind that any amount over that threshold will then go on to be taxed at the adult custodian’s tax rate.

Roth IRAs

You can also invest in the stock market for kids by using a Roth IRA. For children under 18, you can set up a custodial IRA option that will turn into a normal Roth IRA for them once they become an adult. 

A Roth individual retirement account (IRA) is an investment vehicle that lets you hold assets like cash, company stocks, and bonds. 

The biggest advantage of the Roth IRA is that the money essentially grows tax-free. 

Because you fund a Roth IRA with after-tax dollars, the investments are allowed to grow and accumulate tax-free. 

Once the account holder has reached the age of retirement — which is normally 59-and-a-half  — they can withdraw money or assets from their Roth IRA without paying taxes on it.

Chart comparing tax benefits of traditional IRA and Roth IRA Alt: Screenshot of table from Smart Financial Strategies showing differences between Roth IRA and traditional IRA
(Image Source)

However, they’ll incur Internal Revenue Service (IRS) penalties if they want to take cash out of a Roth IRA before they hit the age of retirement. This penalty is normally 10%, although the IRS recognizes a few qualified exceptions to the rule.

If you’re trying to accumulate a big nest egg for the kids in your life, a Roth IRA does have one major drawback: low contribution limits. 

In 2021, the annual contribution limit for under-50s is $6,000 or the total annual earned income of the account holder, whichever is less. If the child in your life doesn’t have any earned income, you cannot contribute to a custodial IRA for them.

529 plans

A 529 plan is an education-focused investment account designed to help adults save over time to help the kids they love pay for college or other educational expenses as they grow up.

If you decide to use a 529 plan to save for a child, it’s important to remember that you won’t be directly buying stock shares. Instead, the 529 account provider you choose will use money that you deposit to invest on a child’s behalf.

These are typically from a pre-selected range of investments, like ETFs or mutual funds. That means a child can indirectly invest in the stock market with a 529 plan — but you’ll be fairly limited in terms of your choice of investment portfolio.

The major advantage of a 529 is that everything you deposit in the account will grow tax-free. 

But unlike custodial accounts, 529 plans also have pretty rigid withdrawal rules. You can only take cash out of the account for a limited set of qualified education expenses, or you’ll have to pay an IRS penalty.

529 plans are designed to help save for education expenses Alt: row of jars demonstrating how 529 plan is for education only, but custodial account can be used for variety of things.
(Image Source)

How Do I Teach a Child About the Stock Market?

Investing in the stock market can be incredibly rewarding — both in terms of developing financial literacy and boosting your own set of financial assets. That’s why loads of adults are understandably keen to teach the kids they love about the stock market.

Fortunately, there are plenty of tools and teaching strategies out there designed to help introduce kids to the world of investment in a safe and controlled way.

A great way to start teaching children about the stock market is to check out some educational stock games and stock simulators. 

Several popular educational stock apps are available in mobile stores or in-browser. They allow kids to explore how the stock market works in a fun and engaging way that speaks to their age — without sacrificing real money.

Teaching kids about the stock market Meta des: Parent and child looking at rising financial figures Alt: Illustration of child on parent's shoulders looking at rising lines on a chart.

In addition to stock simulators, it’s also worth explaining some of the key investment lessons to the kids in your life from an early age. That ensures they will grow up with an understanding of how the stock market works.

These basics of stocks and financial literacy include things like:

  • Risk vs. reward
  • Cumulative interest
  • Profit and loss

Just as importantly, you’ll want to walk kids through the differences between asset classes. 

For example, they might be wondering, “what’s the difference between stocks and bonds?” By explaining these differences early on, the children in your life will grow up with a better awareness of how the stock market works and what various investments mean.

Finally, one of the best ways you can teach kids about stocks is by showing how the market works first-hand.

By investing on their behalf through an investment account like a UGMA custodial account, you can involve the child beneficiary in how you select investments and show them how they grow over time. 

When a child knows the money in an account is theirs, they’re more likely to be engaged in watching it grow over time. 

What’s the Best Investment Account for Kids?

No two situations are 100% alike — so the best type of investment account for the kids in your life might not be the same as everybody else’s. But generally speaking, one of the most flexible options that you can use to invest for kids is a UGMA custodial account.

Not only can you teach the children you love about financial literacy by letting them help you choose investments and watching them generate income, but you and your beneficiary will also get a number of tax and withdrawal benefits. 

Unlike a Roth IRA, UGMA accounts don’t have contribution limits — and unlike a 529 plan, early withdrawals from custodial accounts receive no penalty as long as those withdrawals are for the benefit of the minor.

Finally, the interest you generate on your UGMA investments is taxed at the child beneficiary’s rate up to a certain amount. This may save your family a lot of money in taxes.

There are many similar options to choose from when selecting the right custodial account provider for you. But if you’d like to take your investment potential to the next level in a simpler and supportive way, you can’t do better than EarlyBird.

The UGMA custodial account is a good option to invest for kids. Alt: Father with arm around son standing next to a pile of money.

EarlyBird offers a great introduction to the stock market for kids because it offers clear and carefully curated investment choices. 

When you set up a new account with EarlyBird, you get the chance to pick between five different ETF portfolios. Each portfolio has a range of different investments based on your investment style and financial goals. This places you and the child in control of how your investments grow.

EarlyBird also gives account holders the chance to allocate up to 5% of their account toward value-based funds that support socially responsible businesses. In turn, you’re not only investing in a child’s future through the stock market but also the future of a much broader range of communities.

Yet above all else, what makes EarlyBird one of the best ways for kids to invest in the stock market is that it allows anybody to contribute. 

Using the simple and convenient EarlyBird app, grandmas, uncles, friends, neighbors, coworkers, cousins, or anybody else can instantly gift cash into a child’s custodial account.

Those gifts can then go into the same investment portfolio you’ve already picked alongside the child beneficiary — ensuring that their stock market investments are diversified and continue to grow.

Finally, with EarlyBird, you’ll benefit from unprecedented personalization where gifts and investments are concerned. 

Whenever friends or relatives add a financial gift to a child’s account, they’re able to save video messages alongside the investment. Kids can then watch those messages back years later to truly understand what a major impact all of those contributions have made toward their future.

It’s also worth pointing out that all of EarlyBird’s investment accounts remain with an SEC-registered broker-dealer and a member of FINRA and the Securities Investor Protection Corporation (SIPC). 

Conclusion

Just because the kids in your life aren’t allowed to download all the latest stock apps and start trading doesn’t mean they can’t learn and invest in the stock market. You’ve just got to help guide them.

With EarlyBird, you can teach the children in your life about the stock market while investing for their future.

So, are you ready to learn more about UGMA custodial accounts and how you can teach kids about the stock market? Download the EarlyBird app today.