Smart Ways To Gift Investment Funds To Your Kids

Gifting investment funds to children can be a great way to give them a head start in life and teach them about financial literacy and investing. There are several options for gifting investment funds to children, each with its own advantages and considerations. Here are some of the most common methods:

1. 529 College Savings Plan: This is a tax-advantaged savings plan that allows friends and family to contribute towards a child's future education costs. The money grows tax-free and can be used for qualified education expenses such as tuition, fees, room and board.

2. Custodial Brokerage Account (UGMA/UTMA): These accounts provide flexibility as the funds can be used for any purpose, not just education. The child can access the funds once they reach the age of majority, which varies by state.

3. Roth IRA: If the child has earned income, you can contribute to a Roth IRA on their behalf, allowing tax-free growth and withdrawals for qualified expenses.

4. Direct Stock Purchase Plans: You can purchase stocks directly from selected companies, which may offer physical share certificates that can be exciting for children. However, individual stocks may be more volatile than other investment options.

5. Trusts: Trusts are flexible instruments that can hold various assets, including cash, investments, and real estate. You can also impose rules on how the funds can be used.

Custodial brokerage accounts

A custodial brokerage account is a great way to give a financial gift to a child. These accounts are known as Uniform Transfers/Gifts to Minors Act (UTMA/UGMA) accounts. They are a good option if you want the investment gift to be available for any kind of use, not limited to education expenses.

With a custodial brokerage account, you can invest in stocks, bonds, mutual funds, and ETFs. You also have the option to purchase individual stocks, which may be appealing to parents who want to give their children partial ownership of particular companies they are interested in.

Anyone can contribute to a custodial brokerage account, including parents, grandparents, friends, and other family members. There are no income or contribution limits, and no early withdrawal penalties. The funds can be used for any expenses that benefit the child, such as music lessons, sports team fees, or clothing.

The child who is named as the beneficiary of the account owns all the funds. This means that once the child reaches the age of majority (between 18 and 25, depending on the state), they gain full control of the account and can spend the funds however they wish. It's important to note that the account is also factored into financial aid eligibility and weighs more heavily than assets held in a 529 account.

You can open a custodial brokerage account at any major brokerage, with some microinvesting platforms offering the option to get started with as little as $1 or $5. It's important to note that you can only gift a child up to $15,000 per year before you become subject to taxes.

529 college savings plans

A 529 college savings plan is a tax-advantaged savings account designed for education expenses. It is a state-sponsored investment plan that enables you to save money for a beneficiary and pay for their education expenses. You can make withdrawals from the account tax-free to cover a wide range of college expenses, including tuition, room and board, and textbooks.

Anyone, of any age, with a Social Security or Tax ID number can be a beneficiary of a 529 plan. The beneficiary can even be the same person who sets up the account. To open the account, you must be a US resident, age 18 or over, with a US mailing and legal address, and a Social Security number or Tax ID. There are no income restrictions on 529 plan accounts.

There are two types of 529 plans: 529 tax advantage and 529 prepaid plans. The 529 tax advantage plan is the most popular option and has strong tax advantages. Your investments grow tax-free, and you can also withdraw funds tax-free for education expenses.

A 529 plan can be used at any eligible school, including K-12, two- and four-year colleges, graduate schools, and vocational and technical schools. You can also use a 529 plan to pay up to $10,000 per year, per beneficiary, for tuition at any public, private, or religious elementary or secondary school.

Contributions to a 529 plan (up to a certain amount) are not subject to the federal gift tax. You can contribute up to $90,000 ($180,000 per married couple) per beneficiary in a single year without eating into your lifetime gift tax exclusion.

The account owner of a 529 plan maintains control of the account and can make investment decisions and change the beneficiary if needed. For example, if the intended beneficiary decides not to go to college, you can switch beneficiaries so that another relative can use the money for their education.

When considering a 529 plan, it is important to evaluate the fee structure, timing of withdrawals, taxes, and penalties, and inherent investment risks.

Trusts

There are two types of trusts: irrevocable and revocable. Irrevocable trusts are permanent and cannot be changed, even by the person funding the trust. This type of trust ensures that assets are completely protected. On the other hand, revocable trusts, or living trusts, allow the person creating the trust to retain control, but the assets are subject to seizure by creditors and other parties.

• Specify the purpose of the trust: Decide who the trust will benefit and what assets will be distributed to specific beneficiaries.
• Clarify how the trust will be funded: Trusts can be funded through investments, real estate, or cash.
• Decide who will manage the trust: Choose a trustee who is trustworthy and has the necessary skills to oversee the management and distribution of the trust.
• Legally create the trust and trust documents: This can be done by meeting with an estate planning attorney or using an online service.
• Transfer assets into the trust: Make the trust the owner of any assets you want to be held in the trust by executing a new deed or retitling accounts, investments, or policies.

It is important to review the trust annually and make any necessary changes. Trusts can be a powerful tool to protect and provide for your children's future, but it is essential to set them up properly to avoid complications.

Roth IRAs

A Roth IRA for kids, also known as a custodial IRA, is a great way to give the gift of investment to children. Here's what you need to know about Roth IRAs for kids:

Eligibility

For a child to be eligible to contribute to a Roth IRA, they must have earned income and be 17 years old or younger. Earned income can include money from a W-2 job, such as bagging groceries or caddying at a golf course, or from self-employment gigs like babysitting, dog walking, or yard work. Even infants can qualify if they earn income, such as from modelling. It's important to keep records or receipts detailing the type of work done, when it was done, for whom, and the amount received.

Contribution Limits

The contribution limit for a Roth IRA for kids in 2024 is $7,000 or the total annual earned income, whichever is less. For example, if a child earns $4,000 from mowing lawns, they can contribute up to $4,000 to their Roth IRA. Anyone can contribute to a custodial Roth IRA as long as the child has the earned income to qualify the contribution. This means that parents can make deposits or encourage savings by matching contributions.

Tax Implications

A Roth IRA for kids is funded with after-tax dollars, so when the child withdraws the money during retirement, they won't pay tax on it. Additionally, if the Roth IRA has been open for at least five years, the account owner can withdraw any of the contributed money at any time without tax or penalties. However, distributions from earnings may be taxable and subject to an early withdrawal penalty, unless used for certain purposes such as a first home purchase or medical disability.

Benefits of a Roth IRA for Kids

A Roth IRA offers several benefits for kids:

• Compound interest: Kids who open a Roth IRA can benefit from decades of tax-free growth due to compound interest. Even a single deposit can grow significantly over time, assuming a reasonable rate of return.
• Potentially higher returns than a savings account: Historically, the stock market has provided higher returns than the average savings account, making a Roth IRA a potentially more lucrative option.
• Zero or low-income tax: Since most kids have low or zero income tax rates, they can benefit from tax-free contributions and withdrawals, maximising the advantages of the Roth IRA structure.

How to Start a Roth IRA for Kids

A Roth IRA for a child needs to be started and managed by a parent or other adult as a custodial account until the child reaches the age of majority (usually 18). The child will need a Social Security or other tax identification number, plus earned income. Once the child reaches the age of majority, the account will need to be converted into an individual Roth IRA, giving them irrevocable and legal rights to it.

UGMA/UTMA custodial accounts

There are no limits on the dollar amount of gifts or transfers that can be made to a UGMA/UTMA account, but amounts above $18,000 per year ($36,000 for a married couple filing jointly) will incur federal gift tax. There are no withdrawal restrictions, and the funds can be used for any purpose, including non-education expenses.

The major advantage of UGMA/UTMA accounts is that they make it easy to give financial gifts to a child without having to set up a trust, which can be costly. Anyone can contribute to a custodial account, with no contribution limits, making them valuable gift opportunities for major milestones and celebrations. However, the custodian must transfer the account to the child at a relatively young age (between 18 and 25, depending on the state), after which the money can be used for any purpose.

UGMA/UTMA accounts are a good option if you want to give a child the flexibility to use the funds for any purpose, including non-education expenses. However, it's important to note that these accounts may impact financial aid when applying to college, as they are considered assets owned by the child.

Frequently asked questions