Setting Up An Investment Fund: A Child's Future Security

There are several ways to set up an investment fund for a child, each with its own features and advantages. Here are some of the most common options:

- Custodial Roth IRA: A retirement account that an adult, usually a parent, opens on behalf of a child. The adult controls the account until the child reaches adulthood, at which point control transfers to them. The beneficiary must have earned income for contributions to be made, with a maximum contribution of $7,000 per year.

- 529 Plans: A tax-advantaged savings plan that helps families save for future education expenses. Contributions are not federally tax-deductible, but withdrawals are tax-free if used for qualified education expenses. There is no contribution limit, but a penalty is incurred if the funds are used for non-education expenses.

- Brokerage Accounts: These accounts are opened by parents in their own names and used to invest for their children's futures. The parent maintains full control of the account, even after the child reaches adulthood. There are no restrictions on what the money can be used for.

- UGMA and UTMA Accounts: Custodial accounts that an adult opens on behalf of a child. UGMA accounts are limited to holding gifts of cash, stocks, mutual funds, and insurance policies, while UTMA accounts can hold a wider range of assets. Contributions are irrevocable, and control of the account transfers to the child upon reaching adulthood.

- Coverdell Education Savings Accounts: Similar to 529 plans, these accounts are designed to save and pay for college, elementary, and secondary education expenses. Contributions are limited to $2,000 per year, and there are income restrictions for account holders. Withdrawals are tax-free if used for qualified education expenses.

Custodial Roth IRA

A Custodial Roth IRA is a type of retirement savings account that offers tax-free growth. It is a great way to invest for your child's future and teach them about the importance of saving for retirement. Here are some key things to know about Custodial Roth IRAs:

Eligibility

To be eligible for a Custodial Roth IRA, your child needs to have a source of income. This can include formal employment, self-employment, or even income from babysitting or mowing lawns. It's important to note that the income must be reported to the IRS, and your child should be paying taxes on it.

Contribution Limits

The contribution limit for Custodial Roth IRAs in 2024 is $7,000, or the total amount of money your child earned during the year, whichever is less. For example, if your child made $4,000 from a summer job, they could contribute up to $4,000 to their Custodial Roth IRA this year.

Tax Advantages

Account Management

As the parent or guardian, you will need to manage the account on behalf of your child until they reach the legal age of majority, which is typically 18 or 21, depending on your state. This includes making decisions about contributions, investments, and distributions. However, it's important to remember that the account belongs to your child, and the funds must be used for their benefit.

Withdrawal Flexibility

While the primary purpose of a Custodial Roth IRA is for retirement savings, your child can also make tax-free and penalty-free withdrawals for other important life events, such as buying a home or paying for college expenses. They can also withdraw their contributions at any time without penalties, but if they tap into their earnings before retirement, taxes and penalties may apply.

Opening an Account

To open a Custodial Roth IRA, you'll need to choose a provider, such as Fidelity Investments or Charles Schwab. The process of opening the account is straightforward and can be done online. You'll need to provide basic information about yourself and your child, including Social Security numbers, employment details, annual income, and banking information.

529 plans

There are two main types of 529 plans:

Education Savings Plans

The more common of the two, these plans offer tax-deferred growth, and withdrawals are tax-free when used for qualified education expenses. The account holder contributes money to the plan, which is then invested in a preset selection of investment options, usually mutual funds. How those investments perform determines how much the account value grows over time.

Prepaid Tuition Plans

These plans enable account owners to lock in current tuition rates for future attendance at selected colleges and universities. They are offered by a few states and some higher education institutions. Prepaid plans are not available for K–12 education.

Benefits of 529 Plans

• High contribution limit
• Tax-free withdrawals for qualified expenses
• Flexible plan location
• Easy to open and maintain
• Tax-deductible contributions

Potential Drawbacks of 529 Plans

• Limited investment options
• Fees vary per state
• Restriction on changing plans and switching investments
• Must be used for education

Coverdell Education Savings Accounts

A Coverdell Education Savings Account (ESA) is a trust or custodial account set up in the United States to pay for the qualified education expenses of the designated beneficiary. The account must be designated as a Coverdell ESA when it is created, and the beneficiary must be under 18 or a special-needs beneficiary.

The Coverdell ESA works similarly to a 529 plan, offering tax-free investment growth and withdrawals when funds are spent on qualified education expenses. However, Coverdell ESAs have a maximum contribution limit of $2,000 per year per beneficiary, and they are only available to families below a specified income level.

The income limit for a full $2,000 contribution is $190,000 in modified adjusted gross income (MAGI) for joint filers and $95,000 for single filers. The contribution limit is phased out for MAGIs between $190,000 and $220,000 for joint filers and $95,000 to $110,000 for single filers.

Coverdell ESA funds can be used for a wide range of expenses, including tuition, books, equipment, academic tutoring, and special needs services. The funds must be used by the time the beneficiary turns 30, or taxes, fees, and penalties will be incurred on withdrawals.

Coverdell ESAs are a good option for those saving for private or religious elementary or secondary schools, as the funds can be used for expenses beyond tuition.

UGMA/UTMA Custodial Accounts

The money in a UGMA/UTMA account is considered an irrevocable gift to the child, and the custodian must ensure it is used for the child's benefit. When the child reaches the age of majority, which varies by state but is generally between 18 and 25, legal control of the account must be turned over to the child. At this point, the child gains full access to the account and can use the money for any purpose.

There are several benefits to UGMA/UTMA accounts. Firstly, they are a convenient way to give financial gifts to a child, and there is no need to set up a trust, which can be costly. There are no limits on the dollar amount of gifts or transfers that can be made to these accounts, although amounts above $18,000 per year ($36,000 for a married couple filing jointly) will incur federal gift tax. Additionally, there is no penalty if the account assets are not used to pay for college, and the money can be used for any purpose.

However, there are also some considerations to keep in mind. UGMA/UTMA accounts are considered assets owned by the child, which can impact financial aid when applying to college. Earnings from these accounts are subject to taxes, and the custodian must transfer the account to the child at a relatively young age.

To open a UGMA/UTMA account, you will need the Social Security number, financial information, and bank account number of both the custodian and the beneficiary (the child). You will also need to choose a broker or financial services company that offers this type of account, taking into account factors such as reputation, fees, and investment options.

Brokerage Account

A brokerage account is a great way to teach children about investing and give them a sense of ownership and control. It can also be a fantastic opportunity for parents and children to learn about investing together.

• Select a brokerage firm: Choose a reputable firm that offers custodial accounts for minors, such as Charles Schwab, Fidelity, E*TRADE, Merrill Edge, or Vanguard. Compare the fees, investment options, and educational resources offered by different firms.
• Choose an account type: Decide on the specific type of brokerage account you want to open, such as a custodial brokerage account or a teen-owned brokerage account. Each type of account has different features, restrictions, and tax implications, so be sure to understand the differences before selecting one.
• Gather information: You will need personal information for both the adult opening the account (custodian) and the child (beneficiary), including Social Security numbers, contact information, and financial information.
• Open the account: Visit the website of your chosen brokerage firm and follow their account opening process. This usually involves providing the required information and linking a bank account for funding purposes.
• Fund the account: Transfer money into the brokerage account so that there are funds available for investment. You can typically fund the account with cash, stocks, or mutual fund transfers.
• Start investing: With the account funded, it's time to make investment decisions. The custodian (adult) is responsible for making these decisions until the child reaches the age of majority (typically 18 or 21). Involve the child in age-appropriate decision-making to spark their interest in investing.
• Monitor and educate: Regularly check the account's performance and involve your child in discussions about their investments. Use the account as a teaching tool to educate them about different investment vehicles, asset allocation, and long-term financial planning.

Remember that brokerage accounts for children are subject to certain regulations and tax considerations. Be sure to understand the tax implications of the specific type of account you choose. Additionally, any withdrawals from the account must be used for the benefit of the child.

Frequently asked questions