Minors And Mutual Funds: Smart Investment Choices

There are several options for investing on behalf of minors, each with its own advantages and drawbacks. Here is a list of some of the most popular investment accounts for children:

- Custodial Roth IRA: A retirement account held by a minor but managed by an adult, usually a parent or guardian. The primary benefit is that it doesn't have an age limit for the child as long as there's an adult to manage the account. The caveat is that the child must earn qualified income, and contributions are limited to $6,500 or $7,000 per year, depending on the source.

- 529 College Saving Plans: These plans are specifically designed to save for a child's college education. Funds can be used for various levels of higher education, and there are tax benefits associated with these accounts. However, there may be penalties for using the funds for non-qualified expenses.

- UTMA/UGMA Accounts: Uniform Gift to Minors Act and Uniform Transfer to Minors Act accounts are custodial trust accounts that enable a parent or adult to make contributions on behalf of a child. The main difference is that UTMA accounts allow for a wider range of assets. The child assumes control of the account at the age of majority, which can range from 18 to 25.

- Coverdell Education Savings Accounts: Similar to 529 plans, these accounts are designed to cover elementary and secondary school expenses in addition to college costs. They have a relatively low annual contribution limit of $2,000 and are only available to individuals with an adjusted gross income of less than $110,000.

- Certificates of Deposit (CDs): CDs are a safe and low-risk investment option, as they are insured by the Federal Deposit Insurance Corporation (FDIC). They offer higher interest rates than savings accounts and provide a stable source of income. However, funds are locked up until maturity, and early withdrawal penalties may apply.

- Brokerage Accounts: Opening a brokerage account in the parent's name allows them to maintain full control of the account even after the child reaches adulthood. There are no restrictions on how the money can be used, and there are no tax penalties for non-qualified expenses.

Custodial Roth IRA

A Custodial Roth IRA is a tax-advantaged retirement account that is owned by a minor but controlled and funded by an adult custodian, usually a parent or guardian, until the minor reaches legal adulthood. The benefits of a Custodial Roth IRA are similar to those of a typical Roth IRA: contributions can be withdrawn tax- and penalty-free at any time.

Rules of Custodial Roth IRAs

There is no age limit to Custodial Roth IRAs. Even babies can contribute to a Roth IRA as long as they have earned income. The IRS defines earned income as taxable income and wages from formal employment or self-employment, such as babysitting or dog walking. The Roth IRA contribution limit is $7,000 in 2024 or the total of earned income for the year, whichever is less.

Opening a Custodial Roth IRA for Kids

An adult will need to help open and manage the account. Many Roth IRA providers do not offer custodial Roth accounts, but some do. When choosing a provider, look at the fund fees or management fees to pick the best one for your child. You can set up an account online and will need to provide Social Security numbers, birth dates, and other personal information for yourself and your child.

Advantages of Custodial Roth IRAs for Kids

Contributions can be withdrawn at any time:

Retirement accounts are known for charging a 10% penalty on money taken out before age 59 1/2. However, with a Roth IRA, the money contributed to the account can be withdrawn at any time and used for anything.

More time means more growth:

The longer money is invested, the more it grows. A child who starts investing early has the benefit of more time.

Investing can trump saving over the long term:

A Roth IRA for kids allows children to choose investments, which can lead to higher returns than a regular savings account.

The tax advantages are prime for kids:

Since the Roth IRA is funded with after-tax dollars, qualified distributions in retirement are not taxed. As children's earnings are usually low, they pay little to no income tax, meaning they avoid taxes on contributions.

The money can be used for more than retirement:

Contributions to a Custodial Roth IRA can be used for anything, and there are also loopholes that allow access to investment earnings before age 59 1/2. For example, after the Roth IRA has been funded for five years, the child can take out up to $10,000 in earnings to buy a first home, tax- and penalty-free.

529 College Saving Plans

529 plans are a great way to save for your children's college education. There are two types of 529 college savings plans: educational savings plans and prepaid tuition plans. Educational savings plans allow for tax-free withdrawals as long as the money is used for school-related expenses. Prepaid tuition plans allow account holders to pay for school tuition ahead of time, helping them to avoid student debt.

529 plans are easy to open and maintain, provided the funds are used for qualified expenses. They also have high contribution limits and may have tax benefits, depending on the state. For example, contributions may be tax-deductible, or you may be eligible for a tax credit on your state income tax return.

However, there are some drawbacks to 529 plans. The rules around 529 plans vary by state, and some states have more stringent rules. Additionally, if the funds are used for non-qualified educational expenses, you may be charged withdrawal penalties.

Overall, 529 plans are a great option for parents who want to save for their children's college education and take advantage of tax benefits.

UTMA/UGMA Accounts

UGMA/UTMA accounts are custodial trust accounts that enable a parent or adult to make contributions to a fund on behalf of a child. The custodian can make contributions and invest that money into stocks, bonds, or mutual funds to grow the account balance. Other family members can also make contributions to the account.

The main difference between UTMA and UGMA accounts is the type of assets that can be contributed. UTMA accounts allow for almost any type of asset, while UGMA accounts are limited to insurance policies, securities, and cash.

The custodian will have full control of the account until the child reaches a certain age, which can range from 18 to 25 depending on the state. Once the child reaches the age of majority, they will assume control over the account and can use the funds for any purpose.

One potential drawback of UTMA and UGMA accounts is that they could affect the child's eligibility for financial aid. This is because the assets held in the account belong to the child, and colleges generally expect students to use a portion of their assets to pay for educational expenses.

UGMA and UTMA accounts offer flexibility in how the funds are used. They can be used to help cover the costs of a child's education, but they can also be used for other purposes. However, they do not have as many tax advantages as some other types of investment accounts.

Coverdell Education Savings Accounts

A Coverdell Education Savings Account (ESA) is a trust account created by the U.S. government to assist families in funding educational expenses for beneficiaries. The beneficiary must be under the age of 18 when the account is established, although this age restriction may be waived for special needs beneficiaries.

Coverdell ESAs work similarly to a 529 plan, offering tax-free investment growth and withdrawals when funds are spent on qualified education expenses. However, Coverdell ESAs can also be used for certain K-12 purchases, including books, supplies, equipment, academic tutoring, and special needs services. The maximum contribution limit per child is $2,000 per year, and the accounts are only available to families below a specified income level.

The Coverdell ESA is an attractive option for families wishing to save for elementary and secondary school expenses. It allows for self-directed investments, providing more flexibility than 529 plans, which only allow investments from a predetermined menu of options. Additionally, Coverdell ESAs are considered an asset of the account custodian, typically the parent, and withdrawals are not reported as income as long as they are tax-free.

There are some limitations to Coverdell ESAs. They are subject to eligibility requirements, including age and income restrictions. Tax law prohibits ESA funding once the beneficiary reaches the age of 18, and the relatively low contribution limit may be affected by annual maintenance fees. Additionally, any remaining funds in the account must be distributed by the time the beneficiary reaches the age of 30, unless they are a special needs beneficiary.

Overall, Coverdell Education Savings Accounts can be a valuable tool for families looking to save for their children's education, offering tax advantages and flexibility in how funds can be used. However, it is important to consider the eligibility requirements and contribution limits before deciding if this is the right option for your family.

Certificates of Deposit

To invest in a CD on behalf of a dependent, parents and guardians must open a custodial account, such as a UGMA or UTMA account. The same rules apply as with other types of custodial accounts: you cannot change the beneficiary once the account has been opened, and earnings above a certain amount will be taxed at the parent's rate.

The biggest drawback of CDs is that funds are locked up until the maturity date, and early withdrawal usually incurs penalty fees. Since CDs pay a fixed rate of return, you may also miss out on the potentially higher returns of investing in the stock market or elsewhere.

Frequently asked questions