If you know even just the basics of investing, you know the earlier you start the better your potential for earnings later on, due to the rules of compounding interest. Most of us don’t fully realize this until we’re starting to worry about our retirement years and questioning whether we will have enough money to live on once we stop working. Adults who start investing and planning for retirement in their 30’s and 40’s can’t help wonder how much money they would have if they had only started in their 20’s. But what if we taught our children how to invest while they’re still children?
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Minors cannot legally enter into any binding contract, so it’s not as simple as opening an investment account in your child’s name and contributing money. In most states, children are considered minors until the age of 18 or 21. To start investing before that, however, a parent or another adult can work with the child with “custodial” accounts. Helping a child invest with a custodial account is a little like opening a joint checking or savings account.
Children Who Do Not Earn an Income
If your child is too young to have a job, or isn’t currently employed, they have two primary options for investing and neither have maximum contribution limits:
Custodial Account: As mentioned, a custodial account allows a child to open an investment account with an adult. The child owns the account, but the adult is in control until the child is no longer a minor. If withdrawals are made to the account or dividends are earned, they are taxed at the child’s tax rate. For custodial accounts, there are two options to choose from: the Uniform Transfers to Minors Act (UTMA) and the Uniform Gift to Minors Act (UGMA).
Uniform Gift to Minors Act (UGMA) – Money provided to minors under the UGMA belongs to the child but is controlled by the adult custodian of the account until the age of trust termination is reached (18 or 21 depending on the state). Minors can own securities under the UGMA without the need for an attorney to prepare trust documents. The state the minor resides in will dictate the terms of the UGMA trust. The custodian of the account must count the money in a UGMA as part of their taxable estate until the minor has reached the age of trust termination and takes over the account in his or her name. For college financial aid purposes, the money in a UGMA are considered assets of the student and can affect their ability to receive financial aid funds.
Uniform Transfers to Minors Act (UTMA) – People can send gifts under the UTMA to the minor, including money, real estate; patents, royalties and fine art – and the earnings grow on a tax-free basis for the minor child. An adult manages the account of a minor until the minors are old enough to take over the account. The assets are counted as part of the adult’s estate who manages the account until the minor becomes the legal owner. Keep in mind that assets in a UTMA may count against the child if he or she applies for financial aid.
Guardian Account: In a guardian account, the adult owns the money and shares of stock purchased, and can withdraw it for any reason. You remain in control of the account, all taxes are paid at your own tax rate, but the account is basically designated as funds for your child in the future.
Children Who Earn an Income
For children who earn money from a part time job, mowing lawns, or babysitting, there are additional options for investing – including a Roth IRA.
Roth IRA – as long as your child earns income, he or she is eligible to contribute up to the annual contribution limit for Roth IRAs (or 100% of their earned income) whichever is less. Allowance and financial gifts do not count as earned income. If you are counting income that is earned without a W-2, make sure you keep accurate records of each job (who did your child mow lawns for, how much did they pay, what dates did he mow the lawns, etc). Many companies, such as Fidelity, will not open an IRA for a minor, so you may have to look around to find one that will. Some brokerage firms that will allow IRAs for minors include E*Trade and Charles Schwab.
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