Why Start Investing Early for Children
The single greatest advantage a child has as an investor is time. With decades of compound growth ahead of them, even small amounts invested early can grow into substantial sums. Understanding how to invest for children is one of the most impactful financial decisions a parent, grandparent, or guardian can make.
Consider this example: a $5,000 investment made at a child's birth, assuming an average annual return of 8%, would grow to approximately $109,000 by age 40 and over $235,000 by age 50, without any additional contributions. If you add just $100 per month from birth to age 18, the total could exceed $50,000 by the child's 18th birthday and continue growing for decades after that. The earlier you start, the more time compound growth has to work.
Beyond the financial benefits, investing for children provides an opportunity to teach valuable lessons about money, patience, delayed gratification, and how the financial system works. Children who grow up understanding investing concepts are better prepared to manage their own finances as adults and are more likely to develop healthy financial habits.
Custodial Accounts Explained
A custodial account is an investment account that an adult (the custodian) manages on behalf of a minor child (the beneficiary). The adult makes all investment decisions and manages the account until the child reaches the age of majority, at which point the child gains full control of the assets. Custodial accounts are one of the most flexible ways to invest for a child because there are no restrictions on how the funds can be used once the child takes control.
There are two types of custodial accounts in the United States, governed by state law:
UGMA vs UTMA Accounts
| Feature | UGMA (Uniform Gifts to Minors Act) | UTMA (Uniform Transfers to Minors Act) |
|---|---|---|
| Asset Types | Stocks, bonds, mutual funds, ETFs, cash, CDs, insurance policies | Everything in UGMA plus real estate, patents, royalties, fine art, and other property |
| Age of Transfer | 18 in most states | 18 or 21 (varies by state; some states allow up to 25) |
| Availability | Available in all 50 states | Available in all states except Vermont and South Carolina (which use UGMA only) |
| Contribution Limits | No limits, but annual gifts above $18,000 per person (2024) may trigger gift tax reporting | Same as UGMA |
| Use Restrictions | None after transfer; irrevocable gift to the child | None after transfer; irrevocable gift to the child |
| Financial Aid Impact | Counted as student asset (assessed at up to 20% for FAFSA) | Same as UGMA |
Key characteristics of custodial accounts:
- Irrevocable gifts: Once funds are deposited into a custodial account, the gift cannot be taken back. The money legally belongs to the child.
- Custodian responsibility: The custodian must manage the account in the best interest of the child. Using custodial account funds for expenses that are normally a parent's legal obligation (such as food, shelter, and clothing) may not be permitted.
- Flexible use: Unlike 529 plans, there are no restrictions on how the child uses the funds once they gain control. The money can be used for education, a first car, a home down payment, starting a business, or anything else.
- One beneficiary: Each custodial account has one designated beneficiary, and the beneficiary cannot be changed after the account is created.
529 Plans for Education
A 529 plan is a tax-advantaged savings plan specifically designed for education expenses. Named after Section 529 of the Internal Revenue Code, these plans are sponsored by states and offer significant tax benefits that make them one of the most efficient ways to save for a child's college education or K-12 tuition.
Types of 529 Plans
There are two types of 529 plans:
- Education Savings Plans: The most common type. You contribute money that is invested in mutual funds or similar investments. The account value grows or declines based on investment performance. Withdrawals are tax-free when used for qualified education expenses.
- Prepaid Tuition Plans: Allow you to purchase credits at participating colleges at today's prices, essentially locking in current tuition rates. These plans are less common and are typically limited to in-state public institutions.
529 Plan Tax Benefits
- Tax-free growth: Investment earnings grow without being subject to federal income tax.
- Tax-free withdrawals: Withdrawals used for qualified education expenses (tuition, room and board, books, supplies, computers, and certain K-12 expenses up to $10,000 per year) are not subject to federal income tax.
- State tax benefits: Many states offer income tax deductions or credits for contributions to the state's 529 plan. The specific benefit varies by state.
- High contribution limits: Lifetime contribution limits are very high, typically $300,000 to $500,000 or more per beneficiary, depending on the state.
- Roth IRA rollover: Starting in 2024, unused 529 plan funds can be rolled over into a Roth IRA for the beneficiary (subject to certain conditions, including a 15-year account age requirement and annual Roth IRA contribution limits).
529 Plan Considerations
If withdrawals are used for non-qualified expenses, the earnings portion is subject to income tax plus a 10% penalty. The account owner (usually a parent or grandparent) maintains control of the account and can change the beneficiary to another qualifying family member. For financial aid purposes, a 529 plan owned by a parent is considered a parental asset, which has a lower impact on financial aid eligibility than assets held in the child's name (such as custodial accounts).
Roth IRA for Kids
A Roth IRA for kids (also called a custodial Roth IRA) is one of the most powerful long-term wealth-building tools available for children, but it comes with one critical requirement: the child must have earned income.
Earned Income Requirement
To contribute to a Roth IRA, the child must have earned income from work. This can include wages from a part-time job, self-employment income from babysitting, lawn mowing, tutoring, dog walking, or any other legitimate work. The child can contribute up to the lesser of their earned income or the annual Roth IRA contribution limit ($7,000 in 2024). A parent or other family member can fund the contribution, as long as it does not exceed the child's earned income for the year.
Why a Roth IRA Is Powerful for Kids
- Decades of tax-free growth: A Roth IRA contribution made by a teenager has 45 to 50 years to grow tax-free before traditional retirement age. Even modest contributions can grow to very large sums.
- Tax-free withdrawals in retirement: All qualified withdrawals after age 59.5 are completely tax-free, including all investment gains.
- Contribution withdrawal flexibility: Roth IRA contributions (but not earnings) can be withdrawn at any time, at any age, without taxes or penalties. This provides a safety valve for the child if they need funds before retirement.
- No required minimum distributions: Unlike Traditional IRAs and 401(k)s, Roth IRAs do not require withdrawals at any age, allowing the money to grow tax-free for as long as the account holder wishes.
- Low or zero tax rate: Children typically have little or no income, meaning they pay no federal income tax on their earnings. Contributing to a Roth IRA at a 0% tax bracket is highly efficient because the money will never be taxed, not now and not in retirement.
Coverdell Education Savings Accounts (ESAs)
A Coverdell ESA is a tax-advantaged savings account designed for education expenses. Like 529 plans, contributions grow tax-free and withdrawals are tax-free when used for qualified education expenses. However, Coverdell ESAs have some important differences and limitations.
- Annual contribution limit: $2,000 per beneficiary per year (much lower than 529 plans)
- Income limits: Contributors must have modified adjusted gross income below $110,000 (single) or $220,000 (married filing jointly)
- Broader qualified expenses: Coverdell ESAs can be used for K-12 expenses (tuition, books, supplies, tutoring, uniforms) as well as college expenses, without the $10,000 per year K-12 cap that applies to 529 plans
- Investment flexibility: Coverdell ESAs typically offer a wider range of investment options than 529 plans, including individual stocks and bonds
- Age restrictions: Contributions must stop when the beneficiary turns 18, and funds must be distributed by age 30 (unless rolled over to another family member's Coverdell)
Due to the low contribution limit and income restrictions, Coverdell ESAs are often used as a supplement to 529 plans rather than as a primary education savings vehicle.
How to Open a Custodial Account
Opening a custodial account is a straightforward process that can usually be completed online. Here are the general steps:
- Choose a brokerage: Select a reputable brokerage that offers custodial accounts with no account minimums and low fees. Major brokerages like Fidelity, Schwab, and Vanguard all offer custodial account options.
- Gather required information: You will need the child's full name, date of birth, and Social Security number, as well as your own identifying information as the custodian.
- Select the account type: Choose between UGMA and UTMA (if your state offers both). UTMA is generally preferred because it allows a broader range of assets and may extend the age of custodial control.
- Fund the account: Transfer cash from a bank account. You can make an initial lump sum deposit and set up recurring contributions.
- Select investments: Choose age-appropriate investments. For young children with long time horizons, a diversified stock index fund is a common choice. As the child gets closer to needing the funds, you may shift to a more conservative allocation.
Investment Options for Kids
When investing for children, the long time horizon typically allows for a growth-oriented approach. Here are common investment options suitable for custodial accounts and other child-focused accounts.
Broad Market Index Funds
A total stock market index fund or S&P 500 index fund provides diversified exposure to hundreds or thousands of companies at minimal cost. With 18 or more years until the child needs the money, broad market index funds offer the potential for strong long-term growth while minimizing the risk of any single company's failure. These are the most recommended starting point for investing for children.
Target-Date Funds
Target-date funds automatically adjust their asset allocation from aggressive (mostly stocks) to conservative (more bonds) as a target date approaches. You can select a target-date fund based on when the child is likely to need the money, such as a fund targeting the year the child turns 18 for college or later for retirement. These provide a hands-off, diversified approach.
Individual Stocks
Buying shares of companies that a child knows and uses (such as their favorite toy company, gaming platform, or restaurant chain) can be a powerful educational tool. Owning recognizable brands helps children connect abstract investing concepts to the real world. However, individual stocks carry more risk than diversified funds, so they should complement, not replace, a diversified core portfolio.
Bond Funds
As the child approaches the age when they may need the funds (for college, for example), shifting a portion into bond index funds or a balanced fund reduces volatility and protects against a market downturn at the worst possible time.
Teaching Kids About Money and Investing
Investing for kids is not just about growing money. It is also an opportunity to build financial literacy that will serve them throughout their lives. Here are age-appropriate strategies for teaching children about money and investing.
Ages 5-8: Basic Concepts
- Introduce the concepts of saving, spending, and sharing using clear jars or piggy banks
- Explain that money is earned through work and that people make choices about how to use it
- Use a simple allowance system to let children practice making spending and saving decisions
- Read age-appropriate books about money concepts
Ages 9-12: Intermediate Concepts
- Introduce the concept of compound growth using simple examples and visual charts
- Explain what companies are and how people can own a small piece of a company through stocks
- Let children help choose a stock or fund for their custodial account based on companies they know
- Discuss the difference between needs and wants, and the concept of opportunity cost
- Open a savings account in the child's name and let them see their money grow with interest
Ages 13-18: Advanced Concepts
- Show them their custodial account statements and explain the investment holdings, gains, and losses
- Discuss stock market basics, including how prices are determined and why markets go up and down
- Introduce diversification, risk and reward, and the importance of long-term thinking
- If the teenager has earned income, help them open and contribute to a Roth IRA
- Let them make supervised investment decisions and discuss the reasoning behind choices
- Discuss budgeting, debt, credit scores, and how these financial tools work in the adult world
Tax Implications: The Kiddie Tax
Investment income in a child's custodial account is subject to the Kiddie Tax, a set of tax rules designed to prevent parents from shifting large amounts of investment income to their children to take advantage of lower tax brackets.
For 2024, the Kiddie Tax rules work as follows for children under 19 (or under 24 if a full-time student):
| Unearned Income Amount | Tax Treatment |
|---|---|
| First $1,300 | Tax-free (covered by child's standard deduction) |
| $1,301 - $2,600 | Taxed at the child's own (lower) tax rate |
| Above $2,600 | Taxed at the parent's marginal tax rate |
For most custodial accounts with modest balances, the Kiddie Tax has minimal impact because the investment income (dividends and capital gains) typically falls within the tax-free or low-tax thresholds. However, for larger accounts generating significant income, the Kiddie Tax can result in a higher tax burden. This is one reason some families prefer 529 plans (which grow tax-free) or Roth IRAs for kids (which also grow tax-free) over taxable custodial accounts for larger savings amounts.
When the Child Takes Control
One of the most important considerations with custodial accounts is that the child gains full, unrestricted control of the assets when they reach the age of majority specified by state law (18 for UGMA accounts in most states; 18 or 21 for UTMA accounts, depending on the state). At that point, the custodian's authority ends, and the now-adult beneficiary can use the money for any purpose.
This is a significant consideration because there is no guarantee that an 18- or 21-year-old will use the money wisely. Some parents are concerned about handing over a large sum to a young adult who may not have the maturity or financial knowledge to manage it responsibly. Strategies to address this concern include:
- Financial education: Teaching children about money, investing, and responsible financial decision-making throughout their childhood, so they are prepared to manage the funds when the time comes.
- Gradual involvement: Involving teenagers in reviewing account statements, discussing investment performance, and making decisions about the account prepares them for eventual ownership.
- Using 529 plans for education savings: Since 529 plan account ownership stays with the parent (who can change the beneficiary), parents maintain more control over how the funds are used.
- Trust accounts: For very large gifts, families sometimes use trust structures that allow more control over when and how distributions are made, though these involve legal complexity and costs.
- Open communication: Having honest conversations about the purpose of the account, the sacrifices made to fund it, and the family's hopes for how it will be used can guide the child's decisions.
Despite these concerns, the majority of children who have been raised with financial literacy and who understand the value of their custodial accounts make thoughtful decisions about how to use the funds. The combination of early investing and ongoing financial education sets children up for long-term financial success.
