Investment Options for Kids

During my regular morning Starbucks visit recently I overheard a conversation between two mothers doing what us parents do – brag about the advanced intellect of their children. In this case, 3-year old “Billy” was off all the charts at pre-school and obviously on the fast track to a Harvard full-ride. I, of course, was intrigued and just had to see what toddler budding brilliance looked like so I inconspicuously glanced over….just in time to see “Billy” lick the display glass in front of the pastries. Maybe Billy’s parents would be wise to invest for his future just in case his genius doesn’t reveal itself to those outside his immediate family.

I’m occasionally asked by parents what type of investment account would be appropriate for their children. I always begin this conversation by listing what a family’s saving and investing priorities should be:

1) Retirement – you can borrow for college but you can’t borrow for retirement;

2) College savings – if you’re on track for retirement do your child a favor by saving for their postsecondary education;

3) Beyond college – if you’re on track for retirement and college savings, help your kids save their money for their future beyond their education.

Here are some options:

Custodial Accounts

If a child has collected birthday gifts, allowance and maybe a little money from a job, a custodial account allows them to save and invest beyond an ordinary savings account. When our kids had accumulated a few hundred dollars each and were increasingly disappointed in the 1-cent interest each month they were receiving, we opened a Uniform Transfers to Minors Act (UTMA) account for them. Technically we own the account, with them as the beneficiary until they turn 18, when the account becomes theirs.

Advantage: This is a flexible type of account that allows their savings – from gifts or wages - to be invested in a mutual fund(s) and potentially earn much beyond what mere savings account interest does. They can also withdraw the funds whenever they want to without incurring early withdrawal penalties and the only tax liability might be capital gains. If your child plans to use this money for a car or spending money during college, this is a good vehicle.

Custodial Roth IRA

Like the account described above, a custodial Roth IRA is owned by the parent with the child as the beneficiary, until age 18. At that point, the account becomes an ordinary Roth IRA and the child owns and controls it. One key difference from a regular Custodial Account is that the child must have earned income to contribute to the account and the annual contribution limit is $6,000. For instance, let’s say our friend Billy lands an after-school gig as a nuclear safety inspector at the Springfield Nuclear Power Plant and makes $7500 this year. He can contribute $6,000 to the Custodial Roth IRA.

Advantage: While there isn’t a tax deduction for contributing to the Custodial Roth IRA, the earnings grow tax free so, when withdrawn after age 59 ½, won’t be subject to either capital gains or income tax. The Roth can also be used for a first-time home purchase up to $10,000 without an early withdrawal penalty, if the account has been open at least 5 years. Roths are terrific for long-term saving and investing as the earnings from the investments should compound many times before they withdraw the funds.

Custodial Traditional IRA

The primary difference between a Traditional IRA and a Roth IRA is when taxes are paid on the money that is contributed to the account. Contributions to the Roth are made after tax; contributions to a Traditional IRA are tax-deductible. Like the Roth, the child must have earned income and can only contribute to the extent of that earned income, up to the IRS limit. Even if your child is claimed as your dependent, they may still owe income tax if their income exceeds a threshold established by the IRS - $12,200 this year. Income below that puts the child in the 0% tax bracket.

Advantage: The main benefit of a Traditional IRA is the tax deduction received on each contribution. However, if the child has no tax liability anyway, the benefit goes away as they will pay income tax on withdrawals after age 59 ½, including the earnings. Unless “Billy” is really hauling in the bucks at the Nuclear Power Plant, a Roth IRA is probably the preferred long-term investment vehicle.

Steve Byars, CFP®