Building An Investment Portfolio: Teaching Kids About Money

Investing for kids is a great way to set them up for a secure financial future. It can be a brilliant way to fund their education, purchase their first car, or even help them with a home deposit. The earlier you start, the more your child will benefit from compound growth. Even small contributions can add up over time.

There are a few different types of investment accounts for kids, each with its own advantages and considerations. Here are some of the most common ones:

1. Custodial Brokerage Account: This is an account that a parent or guardian opens and manages on behalf of a minor. The child automatically gains complete control of the account when they reach the age of majority (usually 18 or 21).

2. 529 College Savings Plan: This is a popular option for parents wanting to invest in their children's education. It offers tax advantages, and the funds can be used for qualified college expenses.

3. Coverdell Education Savings Account: Similar to a 529 plan, this account offers tax-free growth and withdrawals for qualified education expenses. However, there are income limits for eligibility.

4. Custodial Roth IRA: This is a tax-advantaged retirement account that an adult opens and manages for a child. It requires the beneficiary to have earned income, such as from a part-time job.

5. UGMA or UTMA Custodial Accounts: These accounts offer flexibility as the funds can be used for anything. Anyone can contribute, and there are no income or contribution limits.

6. Teen-Owned Brokerage Account: Some brokerages offer investment accounts exclusively for teens, allowing them to learn about investing hands-on while giving parents monitoring capabilities.

7. Investment Bonds: These are tax-effective solutions provided by insurance companies or friendly societies, where your money is pooled with other investors and invested according to your choices.

8. High-Yield Savings Account: While not an investment account, this is a great place for kids to build an emergency fund with higher interest rates than traditional savings accounts.

Investment accounts for kids: 529 plans, Coverdell accounts, custodial Roth IRAs, and UGMA/UTMA custodial accounts

529 Plans

529 plans are tax-advantaged education vehicles that are governed by federal law but run by individual states through designated financial institutions. They are a popular choice for parents who want to start investing in their children's educational future. There are no annual contribution limits, and contributions are considered completed gifts to the beneficiary for tax purposes. Distributions are tax-free when used for qualified education expenses.

Coverdell Education Savings Accounts

Coverdell Education Savings Accounts are similar to 529 plans but with stricter contribution limits. They are investment accounts for a child's education, and contributions grow tax-free. Withdrawals are also tax-free when used for qualifying education expenses. The maximum contribution limit is $2,000 per year per beneficiary, and higher-income households have a reduced contribution limit.

Custodial Roth IRAs

A custodial Roth IRA is a tax-advantaged retirement account that an adult, usually a parent, opens and manages for a child. The adult manages the assets until the child reaches 18 or 21, depending on the state. Contributions grow tax-free, and the child can withdraw money, including earnings, for qualified education expenses without paying early withdrawal penalties. The contributions can also be withdrawn at any time, penalty-free, and earnings can be withdrawn early without penalty for qualifying exceptions.

UGMA/UTMA Custodial Accounts

The Uniform Gift to Minors Act and Uniform Transfer to Minors Act (UGMA/UTMA) accounts are types of custodial trust accounts. A parent or relative can open and manage the account on behalf of a child until they come of age, which is typically between 18 and 25. The custodian can contribute and invest in stocks, bonds, or mutual funds to grow the balance, and other family members can also contribute. The main benefit of UGMA/UTMA accounts is their flexibility, as funds can be used for anything, not just education. However, they do not have as many tax advantages as some other options.

Investment goals: Saving for education, a car, or a home

When it comes to building an investment portfolio for kids, it's important to set clear goals and have a well-defined endgame in sight. Here are some tips and strategies to help you build an investment portfolio for your child's future, focusing on saving for education, a car, or a home:

One of the most common and important investment goals for parents is saving for their child's education. Here are some options to consider:

• 529 Education Savings Plans: These plans are specifically designed for saving for future college expenses. They offer tax advantages, such as tax-free withdrawals for qualified education expenses, and anyone can contribute. There are two types of 529 plans: prepaid tuition plans and education savings accounts. The latter is usually a better option as it provides more flexibility in choosing mutual funds and exchange-traded funds (ETFs).
• Coverdell Education Savings Accounts: Similar to 529 plans, these accounts offer tax-free contributions and withdrawals for qualifying education expenses. However, they have strict contribution limits, and higher-income households may not be eligible.
• Custodial Roth IRA: If your child has earned income from a part-time job, they may qualify for a custodial Roth IRA. You can manage the account until your child reaches the age of majority (18 or 21, depending on your state). Contributions grow tax-free, and your child can use them for expenses like a car or a down payment on a house. Additionally, withdrawals for qualified education expenses are penalty-free.
• UGMA/UTMA Custodial Accounts: These accounts offer more flexibility as the funds can be used for education or other purposes. A parent or relative can open and manage the account until the child comes of age. While there are no contribution limits, these accounts may have tax implications for financial aid eligibility.
• Brokerage Account: You can open a brokerage account in your name and gradually transfer the money to your child. This option offers more control and flexibility in picking investments and withdrawing funds, but it doesn't have the same tax advantages as some of the other options.

In addition to education, you may also want to save for your child's other future expenses, such as a car or a down payment on a home. Here are some options to consider:

• UGMA/UTMA Custodial Accounts: As mentioned earlier, these accounts can be used for various purposes, including saving for a car or a home. Once your child reaches the age of majority, they can use the funds as they wish.
• Custodial Roth IRA: While primarily designed for retirement savings, the funds in a Custodial Roth IRA can also be used for a child's first car or down payment on a home.
• Brokerage Account: A brokerage account in your name can also be used to save for these expenses. You have control over the funds and can withdraw them at any time, but keep in mind that selling investments at a profit will incur capital gains taxes.

When saving for your child's future, it's important to prioritize your own financial stability first. Ensure that you are out of debt, have an emergency fund, and are investing for your retirement before allocating funds for your child's investment portfolio. Additionally, involve your child in the process, teach them about investing, and help them understand the power of compound interest.

Investment types: Stocks, bonds, mutual funds, ETFs, and more

Investment types vary, and each has its own advantages and disadvantages. Here are some of the most common investment types:

Stocks

Stocks, also known as shares or equities, represent ownership in a company. When you buy stock, you become a shareholder and have a claim on the company's assets and earnings. Stocks are typically considered a higher-risk, higher-reward investment. They can provide the potential for significant growth over time but also come with the risk of losing value.

Bonds

Bonds are a type of loan made to a company or government. When you buy a bond, you essentially lend money to the issuer, who promises to repay the principal amount (the amount borrowed) plus interest at specified intervals. Bonds are often considered lower-risk than stocks but may offer lower returns.

Mutual Funds

Mutual funds are investment funds that pool money from multiple investors to purchase a diversified portfolio of stocks, bonds, and other securities. They are managed by professional fund managers who decide which investments to include in the fund. Mutual funds offer a simple way to gain exposure to a wide range of investments and are suitable for investors who don't have the time or expertise to build their own portfolio.

ETFs (Exchange-Traded Funds)

ETFs are similar to mutual funds in that they also hold a basket of securities, but they trade on an exchange like a stock. This means they can be bought and sold throughout the trading day, whereas mutual funds are typically traded only once a day after the market closes. ETFs often have lower fees than mutual funds and provide exposure to various investment strategies and asset classes.

Other Investment Options

In addition to the above, there are other investment options to consider, such as:

• Certificates of Deposit (CDs): Offered by banks and credit unions, CDs are a low-risk investment option where you agree to keep your money in the account for a specified period, typically ranging from a few months to several years, in exchange for a fixed interest rate that is usually higher than a regular savings account.
• Real Estate: Investing in real estate can be done through purchasing property directly or through investment vehicles like real estate investment trusts (REITs) or crowdfunding platforms that allow you to invest in a portfolio of properties.
• Commodities: These include tangible assets such as precious metals (e.g., gold, silver), agricultural products, and energy products. They can provide a hedge against inflation and diversify your portfolio.
• Cryptocurrencies: These are digital or virtual currencies that use cryptography for security and are typically decentralized, meaning they are not controlled by any central authority. Cryptocurrencies are highly volatile and speculative investments.

Investment strategies: Hands-on vs. passive, long-term vs. short-term, and low-cost index funds

When it comes to investing for kids, there are several strategies to consider, each with its own advantages and considerations. Here's a detailed look at the different approaches:

• Hands-on vs. Passive Investing: Hands-on investing involves actively researching and selecting individual stocks or investments for your child's portfolio. This approach can be time-consuming and may require a higher level of financial knowledge. On the other hand, passive investing, such as investing in index funds, offers a more hands-off approach. Index funds are like baskets that hold various investments and track specific indices, such as the S&P 500. They provide diversification and steady growth over time without the need for active stock selection.
• Long-term vs. Short-term Investing: Long-term investing is typically adopted when there is no immediate need for the invested funds, usually over 10 years. The primary goal here is the growth of the initial investment. Short-term investing, on the other hand, is used when access to the money is needed in a shorter period, generally less than 3 years. In this case, capital preservation becomes a higher priority. Long-term investing can accommodate more significant risk and volatility, while short-term investing often favours lower-risk investments like bonds.
• Low-cost Index Funds: Index funds are known for their relatively low fees or expense ratios. When choosing an index fund, it's essential to consider these costs as they can eat into your investment returns. Vanguard and BlackRock are known for offering solid index fund options with low expenses. By investing in low-cost index funds, you can maximise the potential for growth while minimising the impact of fees on your child's investments.

By understanding these investment strategies and their differences, you can make more informed decisions about how to build an investment portfolio for your children. It's important to consider your specific goals, risk tolerance, and time horizon when determining the right approach for your family.

Tax implications: Tax-free growth, tax benefits, and gift taxes

When it comes to investing for your children, there are a few tax implications to consider, including tax-free growth, tax benefits, and potential gift taxes. Here's a detailed overview:

Tax-Free Growth:

• Earnings in certain investment accounts can grow tax-free until withdrawal. For example, in a 529 college savings plan, earnings grow tax-free, and withdrawals are also tax-free if used for qualified college expenses.
• Similarly, in a Coverdell Education Savings Account (ESA), contributions grow tax-free, and withdrawals are tax-free when used for qualifying education expenses.
• In a Custodial Roth IRA, contributions grow tax-free, and your child can withdraw contributions (but not earnings) for major expenses after the account has been funded for a minimum of five years.

Tax Benefits:

• While contributions to a 529 plan are typically made with after-tax dollars, you may be eligible for tax benefits as a resident of the state offering the plan. Some states offer tax deductions or credits on your state income tax return.
• With a Coverdell ESA, contributions are not tax-deductible, but withdrawals are tax-free when used for qualified education expenses.
• In the case of a Custodial Roth IRA, contributions are made with after-tax dollars, so there's no upfront tax benefit, but qualified distributions can be withdrawn tax-free in the future.

Gift Taxes:

• When contributing to investment accounts for your children, it's important to be mindful of gift tax implications. Both 529 plans and custodial accounts are subject to gift tax rules.
• For 2022, the annual gift tax exclusion was $16,000 per child. This means that contributions above this amount may be subject to gift tax. However, the specific rules and exclusions can vary from year to year, so it's important to consult a tax advisor for the most up-to-date information.

Additionally, when considering the tax implications of investing for your children, it's worth noting that the type of account and its ownership can impact their eligibility for financial aid when applying for college. Here are a few points to consider:

• Custodial IRA: Money in a custodial IRA is not reported as an asset on the Free Application for Federal Student Aid (FAFSA). However, distributions from the IRA are considered student income, which can affect eligibility.
• 529 Plan: A 529 plan owned by a dependent student or parent is reported as a parental asset on the FAFSA, typically having a smaller impact on financial aid eligibility compared to student assets.
• Coverdell ESA: If a Coverdell ESA is owned by the student or parent, a portion of its value will be included in the expected family contribution (EFC) for financial aid. If owned by a grandparent or relative, only withdrawals are considered for financial aid purposes, and they are treated as student income.
• UGMA/UTMA Custodial Accounts: Assets in these accounts are considered student assets, which carry more weight in financial aid calculations than parental assets.

Frequently asked questions