Teaching children from an early age about the value of saving and investing can help ensure they make wise financial decisions later in life. Your children’s financial security can also be enhanced by establishing custodial IRAs, brokerage accounts, as well as other investments. Or you can just talk openly about your retirement, savings, or even investment accounts. Not only will saving money create a valuable asset that can be used for a child’s formal education, managing the accounts can provide a valuable tool to help you teach your child about investing as well as personal financial literacy in general. Learn about how and why to set up investment accounts for kids below.
Teaching Financial Basics to Kids
Steps you take to teach your children some financial literacy basics may ultimately prove even more valuable than the financial accounts you create for them. Educating children about the concepts of saving, investing, risk vs. reward, compound interest, stocks and bonds will improve their financial literacy and make investing more understandable as they mature. A study from the Center for Social Development (CSD) as well as other organizations show that a kid with a savings account is 4 to 6 times more likely to go to college.
A large number of kids are introduced to saving money by having a so called “piggy bank” (or similar place to keep their change and cash) . Opening a simple savings account or buying a certificate of deposit at a local bank is a common next step. Or using some form of “fintech” app on a smartphone or tablet. While these may provide small financial rewards, they introduce a child to the concept of earning interest and how money can grow simply by leaving it alone.
There are even many technology tools that kids can use to open savings accounts, including iOS and Android smartphone apps. Examples include iAllowance, Savings Spree, and FamZoo among others. Not only can parents or adults open an account for a kid using these apps, but children can also open one on their own. They also teach all about financial literacy. Find apps to teach kids financial literacy or open accounts.
To save money, a child must earn money. The most common way children begin to earn money is by getting a weekly allowance from parents. An allowance should be earned for doing chores, even if simple or quick, so the child develops a sense of having worked for the money.
Once a child has cash in hand, important spending, budgeting, savings and basic financial literacy lessons can be taught. For example, a desire to buy something special can motivate the child to set aside part of each week’s allowance until enough has been saved to buy the item. Have the child keep a written record of purchases and review it weekly. Encourage the child to think about spending decisions and discuss how changing habits can lead to more quickly reaching a savings goal.
Introduce your child to investing at any early age. Start explaining the stock market by discussing the stocks or mutual funds or other investments you own and why you chose those investments. This allows you to discuss profit and loss and that owning stock gives you a piece of the business. Show the child how to read the stock table in the newspaper.
To increase a child’s interest, create a model portfolio by choosing several stocks to follow in companies familiar to the child. For example, this could include Disney, Apple, Nike, Coca-Cola or Amazon. You might even use play money to represent the investment, as there are investment games for kids as well. Or go over the holding in a mutual fund account you may own. Checking stock prices frequently with your child will help to develop a sense of how the market can fluctuate based on events.
After a good grasp of stock concepts is achieved, let the child choose his or her stocks, ETFs or mutual funds to invest in. If you can afford it, buy a few shares and turn make-believe investing into the real thing. Once the child feels comfortable with basic stocks, introduce the concept of diversification and expand a model or real portfolio with low-cost index funds to show the child how to invest in multiple companies with a single transaction. Teach the kid about the pros and cons of mutual funds as well.
In addition to helping children learn important financial concepts, parents can provide a significant future benefit for their children by setting aside money in a proverbial “college fund.” With investment options available today, the accumulated funds may not simply provide a college education or a retirement nest egg, but can also be used to create a firm financial foundation for a child entering adulthood.
Types of Financial Investments for Children
There are numerous types of savings and investment accounts parents can establish, and they are listed below. Tax advantages, annual contribution amounts and how funds can ultimately be used vary. Almost all options will be “custodial accounts” that are controlled by the person (parent or another adult) creating the account until a child reaches the legal age of adulthood at which time the account must be transferred to the child’s control. Almost all the accounts can hold various investments in them ,such as stocks, bonds, ETF, mutual funds or others. The point is to get started, as young investors benefit from compound annual growth.
Custodial Brokerage Accounts
Generally, any adult can open a custodial brokerage account on behalf of a minor. While parents or even grandparents/aunts/uncles most frequently serve as custodians, state laws usually allow accounts to be opened by any adult willing to act as a fiduciary and manage the account in the best interest of the child.
Income in a custodial account is generally taxed to the child. Since most children have little or no earned income, they will generally fall into a lower tax bracket. For the first $2,100 deposited annually, a child will pay less than if assets were taxed at the custodian’s tax rate.
Custodial accounts also generally allow flexibility in how the funds can be used for the child’s benefit. For example, Washington state law allows an account custodian to “pay to the minor or expend for the minor’s benefit so much of the custodial property as the custodian considers advisable for the use and benefit of the minor.”
Custodial accounts must be transferred to the child when he or she reaches adulthood, usually age 18 or 21 as defined by each state. A few states allow accounts to be managed by the custodian until the minor reaches age 25. During this timeframe it is a great idea to teach kids about money and financial literacy, so when the account is transferred to the kid they will be empowered to manage it.
Establishing a basic custodial brokerage account is a great way to both save for your child’s future and to continue teaching the child the basics of investing. As the child gets older and begins earning income, let the child make some real investment decisions and take the actual risk. Even if some money is lost or a financial mistake is made, that can be a valuable learning experience about investing.
UGTMA and UTMA Accounts
When you open a custodial brokerage account, it will likely be governed under one of two federal government acts. The Uniform Gift to Minors Act (UGTMA) and the Uniform Transfer to Minors Act (UTTMA) both allow an adult to open a custodial brokerage account for benefit of a child. Both acts provide fairly simple alternatives to pass on wealth to children without the need to establish a formal trust fund. The essential difference is the type of property that can be held by the account.
- The UGTMA is the more limited of the two and restricts gifts to financial assets such as cash, stocks, bonds, mutual funds, insurance policies and other securities. This will be the most common type of investment that a parent/adult will create for kids.
- The UTTMA allows you to create a custodial relationship with almost any asset and specifically includes real estate, intellectual property, private equity investments and works of art.
For older children who have earned income, opening a custodial IRA is another option. This includes both traditional and Roth IRAs. A Roth IRA has several advantages over a traditional IRA. Financial contributions and earnings in a Roth IRA are considered after-tax money. The investment grows tax-free, and when withdrawals are made later in life, there are no taxes to pay. After a Roth IRA has been established for 5 years, funds can be withdrawn without penalty. Funds might be used for education purposes or purchase of a home, not just saved for retirement.
Children of any age can contribute to an IRA as long as they have earned income. Allowance money, even if earned from doing chores, does not count, but if the child earns money from a paper route, an employer or a self-created business, those funds may be contributed. In other words, in order for a kid or teen to open a retirement account the income needs to be from a “real job”, not an allowance.
Parents can choose to contribute to the child’s IRA as long as the amount does not exceed the child’s earned income. For example, if the child earns $1,000 during a year, the parent can let the child keep the money and donate a gift to the IRA of $1,000. However, even though the contribution came from parental resources the child receives the tax deduction since it is the child’s IRA.
As with custodial brokerage accounts, all funds in the IRA belong to the child and the account must be transitioned to the child upon reaching legal adult age.
Education IRAs are more formally known as Coverdell Education Savings Accounts (ESA). These are tax-advantaged investment accounts with the specific purpose of being used to fund education needs including tuition, books, supplies and uniforms at elementary, secondary and higher education levels. ESA can help pay for college.
Annual non-deductible financial contributions of up to $2,000 annually can be made to the account. The investment grows tax-free. Funds can be withdrawn tax-free as long as they are used for educational purposes. Once the beneficiary turns 18, no additional contributions to the account are allowed.
The account must be completely liquidated by time the beneficiary reaches age 30. Funds not used for educational purposes must be distributed to the beneficiary before that time.
529 Educational Savings Plans for College
These savings plans, named after section 529 of the Internal Revenue Code, may be sponsored by states, state agencies or educational institutions and allow plan holders to set aside post-tax funds that can be used for a beneficiary’s K-12 or college education. They can even pay for a future financial literacy class in college! Plans are available in nearly every state that children as well as teenagers can avail themselves of. It is not required that a person attend a college in the state where the plan originated. Like an education IRA, funds grow tax-free and withdrawals are tax-free when used for eligible educational purposes.
Funds can be used for tuition, meal plans, housing and other eligible education costs. Up to $10,000 per year can be withdrawn tax-free and without penalty to pay for K-12 tuition at public, private or religious institutions per beneficiary. A similar annual amount can also be used to pay for a registered apprenticeship program or financial literacy programs too A lifetime maximum of $10,000 may be withdrawn from the account by the plan holder to pay down a beneficiary’s student loan debt.
The plan holder may be required to pay federal government tax and a penalty if the earnings are not used for qualified educational expenses. To avoid paying tax on any unspent portion of the 529 account, the plan holder can change the beneficiary, keep funds in the account in case the original beneficiary later chooses to go to school or designate the plan holder as the beneficiary and further his or her education.
Getting Started in Investing or Saving for Kids
Find an online broker with low account and transaction fees and that does not require a minimum initial deposit. This will allow children to begin investing with small sums and not hit fees. Choose a broker that offers a variety of investment options including low-cost index funds. Also select one that gives tips, guidance, as well as general financial advice around investing. Finally, to help your child increase investment skills and knowledge, choose a broker that offers online tutorials, free investing advice or other educational content.
Building on a child’s financial knowledge as he or she matures will help to demystify investing and, perhaps, inspire the child to pursue a related career. Teaching children (and even teenagers) about saving and investing at an early age may not make them millionaires by the age of 21, but it may give them the tools needed to ultimately achieve that goal.
By Jon McNamara