As a parent, you want to do everything you can to give your child a great life — today and well into the future. One helpful way to create a brighter, more secure tomorrow for your child is to open an investment account for them. As they grow, so too can the money you’ve put into the account, leaving them with money they can use to fund their educational dreams or head off into the adult world on more stable financial footing. It’s never too early to save money for your child’s future.
It’s also never too late to start investing on your child’s behalf, and there’s a variety of investment accounts and other financial products you can choose from to start working towards these savings goals. Some can even help you teach your child financial literacy in the process. Before you head off to the bank, learn more about your options — including several different types of accounts and how they work — so you can start planning for the future.
How to Use Custodial Brokerage Accounts for Kids
Investing for kids can be as simple as filling out an application and depositing funds into a custodial brokerage account. This is a type of savings account or investment account someone opens up on someone else’s behalf. The account holder is the legal owner of the funds, but an appointed custodian has access to the account and assists the account holder in managing the money. Once money is deposited into this type of account, it becomes the sole property of the account holder — in this case, the child.
Traditional banks, along with investment brokerages, offer custodial accounts. Both you as a parent and your child have the authority to make deposits. The age requirement for your child to be allowed to access the money in this type of account varies based on the state where you live.
You can open a custodial brokerage account either in your child’s name or set it up as a gift that automatically transfers to your child when they reach the age of majority. Throughout the lifetime of the account, you can make monetary contributions to it and determine how the money in the account gets invested. If you opt for a managed account, a financial advisor or robo-advisor can make the investment decisions for you.
Custodial accounts for kids have two main advantages. First, even when your child is still a minor, they’re still legally the owner of the money in the account. This simplifies the process of transferring the money to your child when they become an adult. Second, because your child owns the money in the account, any earnings are taxed at much lower rates. If you were the account holder, you’d need to pay a higher percentage of profits in taxes, and the process of removing the money from the account and transferring it to your child could be taxed as a capital gain.
529 Savings Plans Help Cover Education
A 529 savings plan is an investment account designed to fund your child’s education. You can make deposits at any time, and anyone can contribute on your child’s behalf. Any funds in the plan and withdrawals from it are tax-free and aren’t considered income as long as your child eventually uses them to cover eligible expenses.
These funds can pay for college tuition, off-campus housing, on-campus room and board, and meal plans. Vocational, technical and trade school tuition is also eligible. Students can use a 529 savings plan to pay for internet, software, electronics, books and school supplies. Students with special needs can also use the funds to cover equipment, such as wheelchairs or specialized glasses. Before college, a 529 plan can pay for up to $10,000 of private school tuition annually.
Education-related costs are considered qualified expenses for this type of account. Therefore, there’s no penalty for using withdrawn funds on education. If you end up using the money to pay for a non-qualified expense, however, you’ll pay a tax penalty of 10% of the withdrawn amount. If a child doesn’t go to a private school or later decides not to attend college, they’ll owe 10% of the account money in taxes.
Although each brokerage has different rules, most allow families to contribute up to the gift tax limit each year. For individuals, that amount is $15,000, and for couples, the limit is $30,000. Some brokerages allow annual contributions to exceed the gift tax, but families are then responsible for paying the tax penalty.
Roth IRAs Have Long-Term Advantages
Most brokerages make the process for opening a Roth IRA as simple as filling out an application, and you’re able to establish a custodial IRA for your child. Until your child starts work, you can contribute to the fund up to the annual limits. Then, when your child joins the workforce, they can also start making contributions.
Although this is a retirement account, your child will have some flexibility in deciding how to use the funds. Like a 529 plan, Roth IRA funds are eligible for covering education expenses. If earnings in a Roth IRA are withdrawn before the account holder turns 59.5 years old, the earnings are taxed at 10%. Earnings are the income generated in the account, which is separate from the money you deposited. Your child can avoid the tax penalty by withdrawing all of the deposited cash and leaving all of the earnings — the withdrawal will be considered income for that tax year.
It’s never too early to start saving for retirement, and the prospect of 50+ years of investing can make this type of account valuable for a child who saves the funds throughout their adult life. If your child later maxes out their annual contribution limits when they begin to work full-time, they’ll be set with a sizable nestegg when they eventually retire.
ABLE Savings Plans Help Kids With Disabilities
Like other types of custodial accounts, the funds placed into an ABLE savings account belong to the account holder. However, these accounts are specifically designed for use by children with disabilities. Often, kids with disabilities encounter a wide range of expenses throughout their lives, and many families utilize different forms of government assistance to cover the costs of specialized medical equipment or different levels of nursing care. In addition, if a child has a disability that limits their ability to work, they may also need assistance with expenses in adulthood. However, many forms of government assistance require that an applicant has a maximum of $2,000 in personal assets.
The ABLE savings plan allows families to save up money for kids with disabilities — and the funds in the account don’t count towards maximum personal asset limits that state and other governments set for program eligibility. Although gift tax laws apply, there are no contribution limits, so parents, friends, family and even public funds for people with disabilities can make contributions.
To qualify for an ABLE savings plan, a person has to either have been diagnosed with a severe disability before the age of 26 or be a current recipient of monthly SSI and SSDI funds. Families can use the money in an ABLE savings plan to cover the gaps between an individual’s needs and government assistance, too.
Considering your child’s possible needs, the variety of people who may want to contribute and the possible dollar amount of annual contributions can help you choose the best investment account for your child.