Recently, my daughter misplaced $80 in her room, and it’s simply vanished. One possibility is that we unintentionally donated it to Goodwill while cleaning out some clutter, as she kept it hidden in an old book. This incident made me ponder: Where would be a more effective place for her to store money that she isn’t using?
She has been earning a decent allowance from her chores lately, in addition to receiving cash gifts for her birthday, and she tends to save rather than spend. Perhaps an investment account could be a beneficial option?
While the rules surrounding investing differ slightly for minors compared to adults, starting your child on their investment journey is quite manageable. Even modest gains could ignite an interest in beginning their retirement savings sooner, which can be incredibly advantageous in their future financial life. Here’s how to introduce your child to the foundational concepts of investing.
Choose the Appropriate Account
Kids can open savings, checking, or brokerage accounts under the Uniform Transfers to Minors Act (UTMA) or the Uniform Gifts to Minors Act (UGMA). An adult, typically a parent, must serve as the custodian of the account, which requires you to oversee any transactions and decisions involving the funds until the child reaches the age of majority, which varies from 18 to 21 depending on your state. Since the assets in a UTMA account legally belong to your child, they can only be utilized for their advantage; you cannot withdraw funds or transfer them to another child once deposited.
Establishing a UTMA account is similar to opening any other financial account. You can simply visit a bank or credit union and fill out the necessary paperwork while providing your identification, or register online with platforms like Vanguard.
Your child could also consider a UTMA 529 savings plan, which offers tax benefits for college savings but comes with specific restrictions on eligible expenses.
In addition to a traditional brokerage account, a micro-investing account may be suitable, especially given the small amounts children typically begin with. Services like Stash or Stockpile offer custodial accounts, and Stockpile even collaborates with BusyKid, an app designed to help families manage chores and digitally handle allowances.
To complement an investment account, you might need to set up a checking or money market UTMA account to fund the brokerage account and receive dividends and other returns.
Keep in mind that without earned income, children cannot establish a traditional or Roth individual retirement account. (Refer to: 9 Essential Personal Finance Skills to Teach Your Kid Before They Move Out)
Selecting Investment Options
Once their account is active, children can engage with the same investment vehicles as adults, such as mutual funds, individual stocks, or exchange-traded funds. The choice of products will depend on their level of interest, initial investment amount, and engagement in the investing process.
If a child wants to actively track specific companies and make direct investment choices, they might prefer purchasing individual stocks. It’s essential to find a brokerage that imposes no minimum deposit (or a minimal one) and has low trading fees. While this method offers a practical introduction to the stock market, many financial professionals advise opting for mutual funds rather than stocks for long-term investments.
For those without particular companies in mind but wishing to invest broadly in the market, a mutual fund that tracks the S&P 500 is an excellent choice. The best options come with low fees, allowing more of the investment to remain with your child. However, mutual funds often have minimum investment requirements. For example, Charles Schwab’s recommended S&P 500 index fund requires a $1,000 minimum deposit to open an account, although it’s possible to start with a $100 deposit and commit to additional $100 monthly contributions until reaching the $1,000 threshold.
Exchange-traded funds (ETFs) are another potential investment vehicle, resembling mutual funds but usually featuring lower minimum investment requirements.
Micro-investing apps previously mentioned offer a way to begin with limited initial investments by allowing you to purchase fractional shares of stock or ETFs. By categorizing investments, these platforms simplify the process for younger investors, but typically charge monthly fees; for instance, Stash has a fee of $1 monthly.
While investing in Treasury bonds or certificates of deposit is possible, given the currently low-interest rates, this may not be the most engaging way for a child to learn about investing.
Understanding Tax Implications
Will your child need to pay taxes on their investment earnings? Must they file a tax return on their own? The answer varies depending on the circumstances.
If a child’s investment income remains under $1,050, there’s no need for concern; this amount doesn’t need to be reported to the IRS. For investment income below $12,000, parents can choose to report it on their own tax return or file a return for the child. Once the threshold exceeds $12,000, a separate return for the child becomes mandatory.
What tax rate applies to your child? Generally, unearned income up to $2,100 will be taxed at a rate between 0% and 10%, contingent on the nature of the income. Beyond that, the child’s unearned income will be taxed at the parent’s rate, regardless of whether you file separately or jointly. Therefore, shifting all your investment accounts to your children to minimize taxes won’t work, as the IRS has addressed that strategy.
If your child invests in a UTMA 529 plan, they won’t incur federal taxes (and generally state taxes) on earnings, provided the funds are utilized for qualified educational costs like tuition and textbooks.
Impact on College Financial Aid
When it comes to applying for college financial aid, it’s vital to recognize that a child’s assets are more heavily weighed against them than their parents’ assets. Unless you are certain your family won’t qualify for financial aid, encourage your child to consider short-term savings goals for their investment account, such as purchasing a new Lego set, attending a week-long camp, or saving for their first vehicle.
Opening a 529 plan can alter this dynamic; even if the child is the account owner, financial aid officers view 529 assets as parental assets. This is advantageous since only around 5% of parental assets affect financial aid eligibility, compared to 20% of the student’s assets held in a non-529 UTMA account.
Should your child make college savings investments in their name, advise them to utilize their funds before tapping into a 529 plan or other educational savings you have reserved.
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