How to Open a Brokerage Account for a Child to Invest
Helping your children learn about how to manage their money is a great goal.
One aspect of managing money most people wish they learned about earlier in life is investing.
Due to the power of compounding returns, the earlier you start investing the larger your investment balance could potentially grow.
Your children may want to grow their money to help buy their first car.
Alternatively, they may want to grow college savings to pay for college beyond the low interest rates most savings accounts offer. Investing may be able to help.
If you want to teach your child about investing, one way to do that is by having them start investing themselves. But can a child open a brokerage account? That’s where things get tricky.
Here’s what you need to know about opening a brokerage account for a child and how you can set them up.
Can You Open a Brokerage Account For a Child?
Financial institutions require a person to be a legal adult to open an account, which usually means they must be age 18.
In some rare cases, they may have to be older.
A child cannot technically open their own brokerage account.
While a child can’t technically open their own brokerage account, there are ways to open an account on behalf of a child.
In particular, you can usually set up a custodial account under UTMA or UGMA.
What Are UTMA or UGMA Accounts?
The Universal Transfer to Minors Act (UTMA) and Universal Gift to Minors Act (UGMA) allow adults to set up trusts so that minors can own securities such as stocks and bonds.
Requires a custodian
While minors won’t have direct control over the accounts, the person that donates money into a UTMA or UGMA account appoints a custodian that manages the money within the account.
The custodian has a fiduciary responsibility to manage the money within the account.
The minor could help the custodian make decisions on how to invest the money if the custodian wishes and it is in the best interests of the beneficiary.
Belongs to minor, managed by parents
The money put into a UTMA or UGMA account immediately becomes the property of the minor.
However, the custodian controls the money and how it is invested until the minor reaches the age where the trust terminates.
Parents can use these accounts to help show children how to invest and what to invest in.
Children can learn about buying stocks, bonds, mutual funds and more.
They can also learn about investing for the short-term and the long-term as well as when putting money in a savings account might be a better option.
How Children Can Invest
So how can children invest using a UTMA or UGMA account?
While the child can’t directly make transactions within the investment account, a parent can consult with a child to see how they want to make investments.
The parent can then make transactions based on the discussions with the child.
The "hassle" involved:
For children, the parent must make the transactions if the parents are the trustee.
That means if a parent doesn’t agree with what the child wants to do, they don’t have to do it.
This can be a benefit, though, because parents may have a more level-headed approach than a child may have.
Is Opening a Roth IRA a Good Idea?
Similarly, children cannot directly open a retirement account such as a traditional IRA or Roth IRA. Instead, a parent will have to open a custodial account on behalf of the child.
For most children making very little income, an account like a Roth IRA makes more sense.
A Roth IRA allows children to pay taxes on the income now and withdraw the money in retirement tax-free.
Most children pay no income tax or very little income tax, so a Roth IRA makes more sense than a traditional IRA.
As long as the child has earned income, they can contribute to a retirement account.
In order for income to be considered earned income, it must be taxable wage income.
Children can earn this through a W-2 job. Earned income is also considered self-employment income that taxes are paid on, such as from contracting as a child model for pictures.
The money contributed to a Roth IRA doesn’t have to be the child’s money, but the child does have to have enough earned income to cover the amount contributed to the account.
A head start on retirement savings
As long as a child doesn’t plan to touch the money until retirement, opening a Roth IRA account could be a great idea.
With decades until retirement, the money contributed can grow quite a bit due to the power of compounding returns.
Investing in a Roth IRA as a child could make your child a millionaire by the time they retire.
Let’s say your child starts working at age 12 as a babysitter. They earn $3,000 each summer babysitting until they head off to college at age 18.
The child decides to invest the full $3,000 each year. The money earns an 8% annual return each year until they reach retirement at age 67. At age 67, they’d have a total of $1,076,373. If the money is in a Roth IRA, it should be tax-free in retirement, too.
Obviously, this is a simple example.
The child may earn more or less each year. They may not invest the full amount they earn. They won’t earn an 8% return on their investment each year either.
However, this example shows the power of starting to invest early in life. It’s much easier to become a millionaire when you have more time on your side. The earlier you start, the better your chances are.
What Happens When a Child Turns 18?
If you decide to open a custodial account based on UTMA or UGMA rules, you might be wondering what happens when your child is no longer a minor.
Depending on your state, the UTMA or UGMA rules state the age of trust termination.
For some states, the age is 18.
For others, it may be 21.
Research your state’s requirements to see when a UTMA or UGMA trust account terminates.
When the trust terminates, the custodian should turn over the assets in the trust to the beneficiary.
Don’t Forget About Tax Impacts
Investing can cause tax impacts you may not be anticipating.
A UTMA or UGMA account treats the assets as the child’s. As such, the child will have to pay any income taxes owed on the accounts.
When to file a tax return
If a child receives enough dividends or capital gains from the investments, they’ll have to file a tax return.
Rules for a child’s tax return are different than for a traditional income tax return.
According to the IRS, “If your child's interest, dividends, and other unearned income total more than $2,100, it may be subject to tax.” A parent may be able to elect to include the income on their tax return in certain situations if the income is less than a certain amount.
These rules can get pretty complicated, so it makes sense to consult your tax professional prior to opening one of these accounts to see how it could impact you and your child’s tax situation.
The tax professional can also help you optimize your tax strategy to pay the least amount of tax legally possible.
Another common worry is the gift tax.
Each year, a person can gift $15,000 to another person without worrying about any tax consequences.
After exceeding the $15,000 annual exemption, there is a multi-million dollar lifetime exemption that must be exhausted before gift tax has to be paid in most cases.
Even then, it is generally the person giving the gift that pays the tax.
Your Child May Want to Try a Simulator First
Investing can be tricky.
While your child may think investing with real money is the best way to learn, children can also learn by using stock trading simulators.
The benefit of simulators is you can make mistakes without losing real money.
For instance, children may learn they can’t buy investments based on a gut feeling. Instead, they need to investigate a company’s financials before they invest.
Some people realize simulators are play money and don’t make decisions as if it were real money.
The key to successfully using a simulator is making sure you treat the money as if it were real.
Many people can’t do this, so the only way to learn the lessons is to invest and make mistakes with real money.
Another downside of using a simulator is you won’t start earning the gains you might earn if you invested real money. If you make a great investment within a simulator, you don’t build your wealth. You only build your confidence.
Should You Open a Child Brokerage Account?
Ultimately, the decision whether to open a child brokerage account and what type of account to open is up to you and your family.
You can put assets in your child’s name using a UTMA or UGMA account, but the rules can be a little tricky if you’ve never researched these accounts before.
Consider consulting with a financial advisor and potentially a tax professional, as well, to determine how these types of accounts can impact your family.
In addition to the tax and investment impacts, these accounts can impact college financial aid. Make sure you research and understand all potential implications before you open your account.