Investing young can serve as a bridge to future success. Take the story of an 11-year-old boy who bought three shares of Cities Services at $38 per share. He later sold them for $40 per share, earning a $6 profit. A few months later, he heard that the stock’s price skyrocketed to $200 per share, and he never had to learn the lesson of patience again.
That boy was Warren Buffet. Today, Buffett’s net worth is roughly $95 billion. While I can’t promise that your child will be the next Warren Buffett, I can provide some tools that will contribute to their future financial well-being.
This guide covers various ways to invest for kids. I’ll explore the pros and cons of different accounts so that you and your child can make informed decisions. Here’s what you need to know to invest in your kid’s future.
Why it’s important to invest while young
Investing isn’t just for adults. Children who take advantage of investing can all but guarantee healthy financial returns for themselves in the future. It can also provide them with a roadmap to financial literacy.
Consider this example that highlights the benefits of compound interest. There are two girls – we’ll call them Jessica and Piper. Both get jobs at age 21 and want to invest in an individual retirement account (IRA).
Jessica starts investing $200 a month. She sets up an automatic withdrawal from her bank account so that she doesn’t have to worry about making a deposit. At the age of 30, she turns off the automatic withdrawal and stops investing in her retirement.
Piper isn’t as quick to start investing. She begins making deposits in her retirement account at age 30 and continues to do so until she reaches 67. After the dust settles, Piper has invested $91,200, and Jessica invested $21,600.
Here’s the million-dollar question: who made more money? Jessica, and it wasn’t even close. While Jessica didn’t invest as much or for as long, she leveraged the power of compound interest, something that’s much easier to do when you’re young. Assuming an average interest rate of 8%, Jessica returned $2,547,150 by age 67 and Piper returned $1,383,033.
Just imagine if your kids started investing at an even younger age. They can capitalize on significant returns on investment, allowing them to have more financial freedom.
Investment accounts for kids
Custodial IRA
I’ve already touched on the idea of an IRA. However, children (anyone under 18 according to federal law) can’t open an IRA by themselves. Fortunately, savvy parents can invest in their child’s future through a custodial IRA.
Custodial IRAs come in two flavors: traditional and Roth IRA. The options almost mirror one another, allowing you and your child to put money in an investment account composed of stocks, bonds, and other securities. The only difference is when you pay taxes on the contributions.
A Roth IRA allows your kid to make tax-free withdrawals on all their earnings once they retire. If they withdraw the money before age 59, they have to pay a 10% penalty. A traditional IRA is tax-deductible, allowing your child to reduce their taxable income.
Most children benefit more from a Roth IRA. Chances are that they aren’t making enough money that they need to slide down into a lower tax bracket. However, if they have a job with a 401(k) in the future, a traditional IRA can reduce their taxable income.
You’ll serve as a custodian until your child turns 18. When they become a legal adult, the account can switch hands. The key is persuading your child to leave that money in the investment account so that they can reap the benefits of compound interest.
Just show them how much they can earn using MU30’s compound interest calculator, though, and they may be swayed.
Brokerage account
Looking for an alternative to a Roth IRA? Brokerage accounts are the most common alternative. These taxable accounts allow people to invest in various securities, such as stocks, bonds, and mutual funds.
Brokerage accounts have tax advantages that make them appealing to investors. They also come with few restrictions and can pay dividends, depending on the portfolio’s individual stocks. Like a custodial IRA, you can open the account before your child turns 18 and transfer it to them under the Uniform Gift to Minors Act or Uniform Transfer to Minors Act.
Make sure to find the right broker for your child. Look for institutions that don’t charge fees on each trade or require account minimums. Some brokers that meet these criteria include:
- TD Ameritrade. TD Ameritrade is one of the best online brokers available. You pay no commissions when you trade stocks or ETFs, and the platform is easy to navigate, too. This way, when the account finally changes hands to your child, they’ll have the tools and resources (in addition to the funding, hopefully) to be set up for success.
- E*TRADE. E*TRADE is an excellent option if you’re a more advanced investor or you expect your kids to want to do more detailed analysis. E*TRADE has some of the most advanced charting and research options available. E*TRADE also offers commission-free stock and ETF trading, as well as options, futures, and more.
- Robinhood. Robinhood is another excellent option for parents who want to give their kids the gift of a portfolio with an incredibly easy-to-use app. Robinhood almost gamifies investing (that can be a good or a bad thing), so buying stocks is done through just a few taps. You won’t find the level of research options that you will with something like E*TRADE, but if it’s simplicity you’re looking for, Robinhood is excellent.
You should also consider the tools that brokerage firms offer to young investors. If your child wants to practice stock trading, look for places with practice accounts so that they can hone their skill before investing real money. Brokers often also offer educational courses and tutorials that can give your kids the insights they need to create a long-term investing plan.
Once your child is ready to invest real money, it helps to have a parent’s guiding hand, especially at the start. You can use a couple of strategies to get them excited about investing money. Here’s my recommended two-pronged approach:
- Pick out stocks they know. Set aside one or two individual stocks to let your child choose. Perhaps they love Netflix movies or have a passion for Apple products. Investing in those companies provides extra incentive for them to watch the returns on investment closely.
- Diversify the portfolio with index funds. Index funds serve as one of the safest and most reliable investment options. These low-cost options allow your child to have shares in hundreds of different companies instead of one or two. The portfolio composition will provide an early lesson about the importance of diversification.
529 College Saving Plan
College already costs a small fortune. At the rate we’re going, it’s going to cost even more by the time your child applies to college. Allow your money to make money through the compound interest of a 529 college savings plan.
The 529 plan is a relatively new addition to the Internal Revenue Code, dating back to 1996. It offers parents a chance to make tax-advantaged contributions toward qualified tuition programs. Note if your first child is on the way, you’ll have to wait for the ink to dry on their birth certificate before you open one of these savings accounts.
Other benefits of a 529 plan include:
- Most withdrawals are tax-free.
- They apply to K-12 public, private, and religious schools.
- You can withdraw the money at any time.
- Single parents can contribute up to $75,000 per year.
- Married couples can contribute up to $150,000 per year.
Currently, you can invest in a 529 plan in any state. This flexibility reduces the cost of student loans, especially if your child wants to go to an out-of-state college. However, some states offer scholarship opportunities, financial exemptions, and grants that incentivize parents to invest money in their home state.
You have two choices of 529 plans: savings and prepaid. Savings plans function like mutual funds, tracking market performance through underlying investments. You can choose from various stocks and bonds to customize the portfolio based on your risk tolerance.
Prepaid plans enable you to purchase tuition credits at the current price for future enrollment.
Note that savings plans are only available through the state. Prepaid plans can originate from a state or academic institution. According to SavingForCollege.com, the states accepting new applicants for prepaid plans include:
- Florida.
- Illinois.
- Maryland.
- Massachusetts.
- Michigan.
- Nevada.
- Pennsylvania.
- Texas.
- Virginia.
- Washington.
While 529 plans might not have the appeal of a brokerage account, they can save parents and students from student loan debt. They also come with significant tax incentives and serve as a straightforward, hands-off way to save for college.
CD Ladder
Investing in a 529 plan or brokerage account leaves your kid’s money vulnerable to variable interest rates. While no one can guarantee a return on investment, you can reduce volatility depending on where you invest the money. If you want an ultra-safe and reliable option, check out CD ladders.
CD ladders, short for certificates of deposit, let you purchase multiple CDs at once. The goal is to invest in CDs with different maturation dates and interest rates. When a CD matures, you can roll over the money into a new one, allowing your child to slowly but surely build their wealth.
CD ladders provide peace of mind, no matter what happens in the market. If interest rates rise, your child will have more cash to invest in CDs. If interest rates plummet, the long-term CDs will benefit from higher interest rates.
You may never find a sure thing in investing, but CD ladders are the next best thing. They come with flexible investment options and favorable long-term appreciations. The money in the CD ladder becomes available to your child at any time, so they can withdraw the income when they need it most.
UTMA/UGMA Account
If you have long-term investing on your mind, remember the long name, Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minor Act (UTMA). UTMA/UGMA functions like a custodial IRA. A parent opens it in the child’s name and can transfer it when they reach a specific age.
Most people use UTMA/UGMAs to save for college, though the return on investment isn’t as favorable as 529 college savings plans. That’s because parents have to make contributions with after-tax dollars. A single adult can contribute $15,000 per year to the savings account, while a couple that files jointly can deposit $30,000.
While UTMA/UGMAs lack some of the upsides of 529 college savings plans, they have unique advantages. For example, 529 college savings plans require your child to use the funds on tuition or other educational expenses. UTMA/UGMAs have greater flexibility so that children can spend the funds on anything.
UTMA/UGMAs serve as a complement to 529 college savings plans. They help pay for non-qualified expenses related to academia, such as application fees, uniforms, and health insurance. If you’re in search of a low-cost option, check out Ally Invest and TD Ameritrade. Both offer a range of investment products with no monthly fees or minimum balances.
Other ways to invest in your child’s future
Begin building credit
Your credit score goes hand-in-hand with financial responsibility. Those three numbers can make all the differences when applying for a loan or negotiating a mortgage. Giving your child a jump on their credit score can ensure that they have a positive credit history when they reach adulthood.
Taking a “sooner rather than later” approach can show your child the importance of financial literacy. They’ll see the impact that credit scores have when renting an apartment or getting a phone plan. Here are three ways you can bolster your child’s credit score:
Make your kid an authorized user on your credit card
The adage is that high tide lifts all boats. That saying extends to credit scores as well. If you have an impeccable credit history, you can help your child by adding them as an authorized user to your account.
Authorized users may or not have their own credit cards. It’s up to you as a parent. However, authorized users reap the benefits of on-time credit card payments and a low debt utilization ratio. These activities establish a sturdy foundation for your child’s credit history.
Give your child a secured credit card
Secured credit cards offer a friendly entry point into adulthood. These credit cards cater to individuals with no credit history and often have no annual fees. Companies secure the cards with collateral, usually from a bank account, in case the cardholder doesn’t make timely payments.
A secured credit card allows your kid to get a taste of the real world. They can learn the importance of paying their monthly statements and limiting their debt. Make sure your child understands the terms and conditions before they agree to use the credit card.
Have your kid pay their student loans on time
Paying student loans can incrementally build your child’s credit score. That applies whether they pay back the debt during school or after they graduate. However, if they miss a single payment, it can offset months of hard work adding to their credit score.
Buy life insurance
A life insurance policy offers an affordable way to protect your loved ones now and in the future, and you can purchase life insurance policies for children. They work like the adult version with a monthly or annual premium. The insurance provider will pay a death benefit to the beneficiary if the policyholder dies.
Most people opt for whole life insurance policies for their children instead of term life insurance. This option offers protection for as long as the policyholder pays premiums. The premiums are a flat rate, meaning the insurance provider won’t increase the price over time.
Purchasing protection for your child is simple and straightforward. All you have to do is fill out an application and sign some electronic forms. Kids don’t have to go through a physical to secure the policy.
Start a Health Savings Account (HSA)
You can think of HSAs like a 529 college savings plan. You contribute tax-advantaged dollars that you can use for qualified expenses. The difference is that the funds from HSAs go toward medical costs instead of college.
An HSA supports your child for any medical expenses that don’t fall under the coverage of a high-deductible health plan (HDHP). That can include vision, dental, and prescription drug care. You also don’t have to pay taxes on HSA contributions or earned income.
Step one to investing in a kid’s HSA requires determining your qualifications. The IRS has a list of eligibility standards to decide who can create the account. Eligible individuals must have:
- A qualified HDHP.
- No other health coverage.
- No Medicare benefits.
- No one that claims them as a dependent on tax returns.
Individuals can contribute up to $3,600 to an HSA. If you file your taxes jointly, you and your spouse can deposit up to $7,200 in the account as of 2021. Anyone over the age of 55 can make an additional $1,000 contribution each tax year.
Put money in a trust fund
Trust funds aren’t strictly for the wealthy. You can use them to pass on money and assets to your child, even if you’re not a multimillionaire. They allow you to use your wealth in specific ways so that you can invest in your child’s future.
If you’re fuzzy on how a trust fund works, that’s okay. Most people don’t understand them either, which is why only 0.95% of Americans have one. Here’s an example to illustrate how a trust fund operates:
You’ve worked hard your entire life and built a comfortable financial cushion in the process. You know you’re going to die at some point and want to ensure that your savings go to your loved ones. However, you want them to use the money responsibly.
Additionally, you want your money to go to your grandchildren and future generations. In this case, you can establish a living irrevocable trust fund. The trust fund dispenses cash under certain conditions, which can include when you’re still alive.
You can place a range of assets in a trust fund, such as real estate, stocks, bonds, and money. You have to work out the details with an attorney to determine when your child will receive payments and how much. After all, it’s your money, so you should decide what to do with it.
Trust funds offer various benefits. If your kid applies for financial aid, they do not have to claim the trust fund as an asset. That way, they can maximize their eligible aid.
While trust funds come with numerous fees and high attorney costs, they have some advantages over a traditional will. Trust funds don’t have as many tax implications, and they’re more difficult to challenge through probate. If you want complete control over how your wealth will go to your kids, trust funds deserve your consideration.
How do I talk about investing with my kids?
Talking to your kids about investing can be tricky, especially when you have to compete with Minecraft and soccer practice for their attention. Don’t worry. You can show your kids the importance of investing with time and patience.
Start by talking about investing consistently. Investing shouldn’t be a one-time conversation. You can continue to nurture their interest if you talk about the stock market, mutual funds, and money market accounts every week.
Of course, your kid might not understand terms like “stock market” or “money market accounts.” Skip the jargon and use simple, direct language instead. If you paint a big picture for them, your child will have an easier time engaging with the overarching ideas.
You can also spark their interest by using investing examples that apply to their lives. Explain how Netflix and Nike create the shows and sneakers they love with investment capital. When your children reach their teens, you can use their favorite hangout spots, like Starbucks and Wendy’s, as examples.
What should I look for in a broker?
The best broker for your needs might be the best broker for your kids. For example, your child probably won’t deal with thousands of dollars. That means you can save them money with a broker that doesn’t charge a litany of fees.
Some things to look for in brokers for kids include:
- Low fees.
- Low account minimums.
- Various investment products.
- Easy-to-use website interface.
- Educational resources and tutorials.
Remember that every broker has distinct strengths. Robinhood caters to people on a budget, while Fidelity empowers investors who want to bolster their retirement savings.
Do brokers offer practice accounts for investors?
In 2014, Motif held an investing competition. (Motif is a discount stockbroker that lets investors purchase stocks based on a theme.) It had investing clubs from different universities pick individual stocks to see who could earn the highest return on investment.
The competition had entries from Yale, the University of Pennsylvania, Columbia, and Cal-Berkeley. When the dust settled, though, the winning team was “Math Minions,” a group of sixth-graders from Fargo, North Dakota. The students returned 21.6% on their investment, besting the second-place McIntire Investment Institute at 18.5% and the S&P 500 at 10.2%.
In a perfect world, your child will figure out how to invest in no time. Unfortunately, we don’t live in a perfect world. One way to moderate the risk of losing money is to let them use a practice account before dealing with actual cash.
Practice accounts, also known as stock stimulators, let kids buy, sell, and trade assets. The only difference is that there’s no money on the line. It provides them a first-hand learning experience without any financial risk.
Webull has an excellent stock stimulator you can use before you sign up for an account. It lets you practice investing before you actually invest, so you can test out different strategies. For a kid, this would be an incredible opportunity to test the markets and learn real-time, without the risk.
What is the kiddie tax rule?
You may have realized that investing for kids can serve as a tax loophole. Why not purchase a bunch of individual stocks and write off the investment by gifting it to your child? In 1986, the federal government passed a tax law known as the kiddie tax, preventing people from taking advantage of this loophole.
The kiddie tax requires parents to pay the marginal income tax rate on all unearned income. This special law applies to any kid under 19 or full-time students under 23. While the kiddie tax pertains to unearned income, it doesn’t require children to pay a higher tax rate on salary or wages that they earn.
As a rule of thumb, the IRS allows the first $1,000 of investment income to go tax-free. The second $1,000 is taxable at the child’s income tax rate. This rate is lower than what parents would pay under a marginal income tax.
How old should my kid be before I let them invest?
Every kid is different. Some children show an early aptitude for investing, while others never develop an interest. Most kids understand the basic concepts of investing around age eight.
Give your child a chance to learn through hands-on experience. While you don’t have to hand over several thousand dollars worth of index funds, you can expose them to your favorite investing book or allow them to choose stocks in a portfolio. Your kid will feel invested in a company like Snapchat if they know it’s responsible for their favorite social media content.
What is micro-investing, and how can I use it to help my children?
So far, we’ve touched on large-scale, long-term investing. If you want to hit the ground running with investing for kids, that’s great. It’s not the only option, though. The past decade has seen a surge in micro-investing, which involves saving small amounts of money.
You can think of micro-investing like putting money in a jar. You put spare change aside until the coins reach the top. Digital platforms allow you to do the same thing by rounding up your purchases to the nearest dollar and depositing the difference into your savings account.
For example, your kid might spend $2.50 on lunch every day at school. The investment platform will round that purchase up to $3 and deposit $0.50 from your child’s bank account into the savings fund. That translates to roughly $125 in annual savings before interest.
Probably the most popular micro-investing app is Acorns, which now offers a variety of account options. In addition to being able to round up your purchases and put the difference in an ETF, Acorns gives you options for setting up an IRA, a checking account, and even investing directly for your kids.
Micro-investing doesn’t require automatic investments, but it can help your kids save money. You can help your kids set up weekly, biweekly, or monthly deposits, whether that’s $5 or $500. The platform takes care of the transaction, so you and your children don’t have to save money manually.
Summary
Give your child a head start on a good financial future. Early investing can open doors to new opportunities and provide an economic safety net. It can also teach them vital skills and financial literacy that help them make savvy investment decisions as an adult.
The best investment options will depend on your child’s needs and interests. If you want to plan for the long-term, consider a 529 plan or custodial IRA so that you can help your kid save for significant life expenses. If your kid has shown an interest in individual stocks or bonds, try opening a brokerage account for them.
To ensure that you make investments that satisfy your child’s best interests, talk with a financial advisor. They can provide guidance and insights to put you on the path toward success.