Getting Your Child Started with Investing

Recently, I discovered that my daughter had misplaced $80 in her room. It’s mysteriously vanished. One possibility is that we accidentally donated it to Goodwill, given that she had hidden it in an old book during our recent decluttering. This incident made me ponder: Where would be a more secure location for her money?

She has been earning a decent allowance from her chores lately, and she also receives cash gifts on her birthdays, keeping her expenditures minimal. Perhaps an investment account would be ideal?

Though the investment regulations differ for minors compared to adults, initiating an investment journey for your child is relatively straightforward. Even a small amount of earnings can instill in them the importance of investing early for retirement, leading to a more secure financial future. Here’s how to teach your child the fundamentals of investing.

Choosing the Right Account

Children can establish savings, checking, or brokerage accounts through the Uniform Transfers to Minors Act (UTMA) or the Uniform Gifts to Minors Act (UGMA). The requirement is that an adult, likely you, serves as the custodian. This means you must approve your child’s financial decisions until they reach the age of majority, which varies by state (either 18 or 21). Since the assets in a UTMA belong to your child, they can only be utilized for their benefit once deposited—withdrawals or transfers back to you are not permitted.

Opening a UTMA account mirrors the process of creating any other bank account. You could visit a local bank or credit union or register online with platforms like Vanguard after completing the necessary documentation and providing identification.

Your child might also consider setting up a UTMA 529 savings plan, which is designed for college savings with tax benefits, although it does have restrictions on usage. More details on this are provided below.

In addition to a conventional brokerage account, your child can explore micro-investing accounts, allowing them to start with minimal funds. Platforms like Stash or Stockpile offer custodial accounts, and Stockpile even collaborates with BusyKid, an app for managing chores and digital allowance payments.

Besides the investment account, consider establishing a checking or money market UTMA account for your child. This would facilitate funding the brokerage account and serve as a receipt for dividends and other income.

Keep in mind that unless your child has earned income through employment, they’re ineligible for traditional or Roth IRA accounts. (See also: 9 Essential Personal Finance Skills to Teach Your Kid Before They Move Out)

Understanding Investment Options

After setting up the account, children can access the same investment opportunities as adults, including mutual funds, individual stocks, and exchange-traded funds. The choice of investments will depend on their interests, the initial amount available, and their desired level of involvement in managing investments.

If your child is keen on monitoring specific companies and making active investment decisions, purchasing individual stocks might appeal to them. Seek a brokerage with no minimum deposit or affordable trading fees. While engaging, ensure your child understands that seasoned financial advisors often suggest investing in funds rather than specific stocks for long-term gains.

If your child lacks specific company interests but wishes to invest in the broader market, a mutual fund such as an S&P 500 index fund could be an excellent choice. Quality mutual funds usually have low fees, which means your child can retain a larger portion of their investment. However, mutual funds often require a minimum investment. For example, to invest in Charles Schwab’s popular S&P 500 index fund, you need a $1,000 initial deposit. Alternatively, you can open a Schwab account with a $100 deposit but must contribute an additional $100 monthly until it reaches $1,000.

Your child may also explore exchange-traded funds (ETFs), which operate similarly to mutual funds but typically require lower initial investments.

Another feasible option for a small initial investment is to utilize micro-investing apps that allow you to purchase fractions of stocks or ETFs. These platforms simplify the investment process for young users by categorizing investments. However, they usually charge a monthly fee, such as Stash’s $1 monthly subscription.

While investing in Treasury bonds or certificates of deposit is an option, the current low interest rates might not provide an engaging experience in learning about investing.

Tax Implications

Are there tax obligations for your child on their investment gains? Do they require filing their own tax return? The answers depend on various factors.

If their investment income is below $1,050, there’s no need for concern; this income doesn’t need to be reported to the IRS. If the earnings are under $12,000, parents have the choice to report it on their own return or file a separate return for their child. If it exceeds $12,000, a tax return for the child must be filed.

What tax rate applies? For unearned income up to $2,100, the tax rate ranges between 0% and 10%, based on the type of income. Beyond that threshold, any excess unearned income will be taxed at the parent’s rate, regardless of whether filing is done separately or jointly. Therefore, transferring investment accounts to your children won’t yield significant tax savings—this loophole has been recognized by the IRS for years.

If your child invests their money in a UTMA 529 plan, they won’t incur federal (and usually state) taxes on earnings as long as the funds are utilized for qualifying educational expenses, such as tuition and books.

Impact on Financial Aid

It’s essential to understand that when applying for college financial aid, assets owned by the child have a more considerable negative impact compared to those held by the parents. Unless you’re confident that your family won’t qualify for financial aid—which is often uncertain—advise your child to set short-term goals for their investment account, like buying a new Lego set, attending a week of camp, or saving for their first vehicle.

Nevertheless, if investments are held in a 529 plan, it alters the dynamics somewhat. Despite the child being the account owner, financial aid officers treat 529 account assets as parental assets. This is advantageous because only about 5% of parental assets affect financial aid eligibility, in stark contrast to the 20% of student assets from non-529 UTMA accounts.

Encourage your child to utilize their personal funds first before drawing on a 529 plan or other educational savings you have set aside for them.