Teaching kids the value of a dollar and setting them up for success are two righteous goals for parents and others with youngsters biting at their ankles. If you believe children are the future, you can teach them well by opening an investment account that’s specifically designed for kids.
Top investment accounts for kids
There are four primary types of investment accounts for kids, each with their own rules and tax considerations. Kids can also invest in regular brokerage accounts, which we’ll discuss further below.
1. 529 college savings plan
A 529 college savings plan provides a tax-advantageous way to save for qualified higher education expenses. The primary tax benefit is that the Internal Revenue Service (IRS) does not tax 529 account withdrawals as long as you use them for education expenses.
If the original beneficiary of the account chooses to not use the funds for college, you can change the beneficiary with, in most cases, no tax consequences. You can also opt to roll over 529 proceeds into a Roth IRA.
Generally, states administer 529 college savings plans, so start there because some states offer tax incentives to their residents. However, you don’t have to go with your state’s plan. If you go through a brokerage, you might wind up in another state’s plan. For instance, Schwab’s 529 plan, according to the company, is “administered by the state of Kansas with American Century Investments as the program manager.”
2. UGMA/UTMA custodial account
Uniform Transfers to Minors Act (UTMA) and Uniform Gifts to Minors Act (UGMA) custodial accounts are two types of brokerage accounts opened and managed by an adult for a minor. The adult makes investment decisions in the account until the beneficiary reaches the age of majority, which varies by state, but can only use account proceeds to benefit the child during this period. Once the child reaches the age of majority, they assume control of the account.
3. Coverdell ESA
As the IRS explains, “A Coverdell education savings account (Coverdell ESA) is a trust or custodial account set up in the United States solely for paying qualified education expenses for the designated beneficiary of the account.” You can use the account not only for higher education costs, but for qualified elementary and secondary education outlays.
The potential downsides: You can only contribute $2,000 per beneficiary across all Coverdell ESAs, and your contribution limit starts to decrease at a modified adjusted gross income (MAGI) of $95,000 for single filers ($190,000 for joint filers) and gets completely phased out at $110,000 ($220,000 for married filing jointly taxpayers).
As with a custodial account, assess the overall offering of a brokerage before deciding where to set up a Coverdell ESA. In our review of the landscape, there were no notable differences between firms offering this type of investment account for kids.
4. Custodial Roth IRA
A custodial Roth individual retirement account (IRA) functions the same way as the aforementioned custodial account. However, it plays by the rules set by the federal government for Roth IRAs. To this end, in order to open this type of investment account for kids, the minor must have earned income, most likely from part-time work.
According to financial services firm Charles Schwab, “In addition to reaping the benefits of compounded growth, your child may be able to use the funds for future expenses like college tuition or even to buy a first home. You can open either a Custodial Roth IRA or Custodial Traditional IRA, and the respective account benefits and rules apply.”
While compiling our list of the best custodial accounts for 2024, we discovered that there isn’t much distinction between custodial accounts on features. Given that the custodial tag is merely an account designation, this makes sense. Evaluate a brokerage’s overall services first. This assessment will ultimately determine where you open a custodial account.
For example, we determined that the Schwab One custodial account is best for more active traders given features such as fractional share investing. As a Charles Schwab spokesperson told CNN Underscored, you “can also gift fractional shares to a funded custodial account through Schwab Stock Slices.” Here again, this feature of the Schwab brokerage platform is ideal for use in a custodial account where part of the point is often to teach kids about investing with a small amount of money.
5. Brokerage account for kids
Beyond these common and tax-advantageous investment accounts, kids can also invest in a good old-fashioned taxable brokerage account. If you can find one aimed specifically at minors, it will — more or less — function like a standard brokerage account for adults.
The best example of this type of account our team could find is the Fidelity Youth Account. This account is not a custodial account. Rather, it is, in Fidelity’s words, “a teen-owned brokerage account” that comes with a debit card, an app and is “owned by the minor, who makes all the investment decisions.” Fidelity provides this account with no fees or minimums and easy adult oversight but with a limited investment selection of “most US stocks,” Fidelity mutual funds and “some exchange-traded funds (ETFs).”
Of course, there are tax considerations with this type of account that we will cover in a minute.
Marketing investment accounts to kids
Some companies market other investment and, more so, savings vehicles for kids, including teen checking and savings accounts, typically found at banks. Others focus heavily on education and giving kids — and other beginners — a head start on investing.
Schwab, for example, introduced the Schwab Starter Kit in December 2021, available to all investors. If you make a $50 deposit into this account within 30 days, Schwab gives you $101 and splits it evenly, as a Schwab spokesperson explained, “across the top five stocks in the S&P 500.” The account provides “access to tailored educational content designed to be easily digestible for someone learning about investing and curated easy-to-use investing tools and resources.”
Other firms, including Acorns, market accounts, such as custodial accounts, to entice young investors (or, at least, their parents). CNN Underscored named Acorns Early best for young, aggressive investors in our best custodial accounts ratings, in part, because it places all custodial accounts into its aggressive portfolio geared toward investors with long-term time horizons.
Steps to open an investment account for your kid
Generally, the account opening process is not all that different from opening a bank or brokerage account:
- Decide what type of investment account you would like to open for your child.
- If it’s a 529 plan, consider checking out your state’s direct offering first.
- If you go directly to a bank or brokerage to open an account, their website will properly direct you.
- In many cases, particularly when you open a custodial or individual retirement account, you will choose the appropriate account designation during the application process.
- Have your personal information, including Social Security numbers, ready.
- Link your account to a bank account to make the initial deposit and subsequent transfers.
Investment accounts for kids compared
Advantages of starting to invest early
The early bird gets the worm and realizes the beauty of compound growth.
An early education
Hayley Wood Bates, a certified financial planner and financial advisor with Signature Estate & Investment Advisors, told CNN Underscored that her “clients usually have a specified value system of which they want to impart on their children by way of beginning an investment account while their children are under the age of majority.” With an understanding of this value system, Bates can get the client into the best type of investment account for their kids.
Generally, everything from teaching kids how to invest to giving them semi-control over a bank account and debit/credit card can help build good money-related habits early.
A head start on compound growth
Compound growth is essentially the dynamic of earning money not only on your principal investment but on your principal plus accumulated interest.
The US Securities and Exchange Commission (SEC) maintains a useful calculator to help you visualize the power of compound growth. As an example, if you put $500 a month under your mattress, you would have — assuming the mice don’t eat away at your bills — $6,000 at the end of one year. However, if you send that $500 a month to a high-yield savings account earning a 5% annual percentage yield (APY), you would have $6,139 at the end of the year.
A similar situation applies to investments. Using dividend stocks as an example, if you invested $10,000 in the S&P 500 index 10 years ago and did not reinvest dividends, you would have had roughly $28,071, as of July 2024, good for an average annual return of 10.9%. However, with dividend reinvestment (one of investing’s most popular iterations of compound growth), you would have wound up with approximately $33,548, good for an average yearly return of 12.9%.
So, clearly, the earlier you get your kid saving and investing, the longer the runway to realize the exponential rewards of compound growth.
Impact of a child’s investment on taxes and financial aid
Financial aid
Per Schwab’s website, here’s how the government deals with the presence of investments when calculating financial aid: “Your student’s eligibility for financial aid is determined largely by your Expected Family Contribution (EFC), which is the amount of college expenses the Federal Student Aid office estimates you can pay.
The amount of aid you’re eligible for is the difference between your EFC and the cost of attending a specific college. Your EFC doesn’t change based on what school your child chooses to attend, so don’t exclude a school simply because of cost — especially before applying for financial aid.”
“Your EFC takes into account both the parents’ and the student’s income and assets, excluding home and retirement assets. Generally, 20% of a child’s assets and 5%-6% of the parents’ assets are used for evaluation,” Schwab writes.
According to Schwab, parental assets include:
- Cash and savings and checking accounts
- Non-retirement investment accounts
- 529 plans
- Education savings accounts
A student’s assets include:
- Cash and savings and checking accounts
- Non-retirement investment accounts
- Custodial accounts
Taxes
As for taxes, Schwab writes that as “a parent, your child’s taxable income is inherently linked to yours.”
To get an accurate handle on your situation, it’s best to consult a tax pro because, as Schwab continues, “In some cases, you may be able to include their income on your tax return. In other cases, they’ll have to file their own tax return or you will have to file a separate return on their behalf. Depending on the level of your income, including their income on your tax return may result in higher income tax than if you prepare a separate return for your child.”
Generally, Schwab writes, your child will need to file a return if:
- Their unearned income (such as investment income from dividends or interest) was more than $1,250 for 2023. That figure increases to $1,300 for 2024.
- Their earned income (income from employment) was more than the standard deduction of $14,600 for 2024.
- They have net earnings from tips or self-employment that total $400 or more.
Schwab adds that those amount apply to kids who are “age 18 or under on December 31 and whose earned income does not exceed half the annual expenses for the child’s support” or those who are “a full-time student over 18 and under 24 on December 31 and whose earned income does not exceed half the annual expenses for the child’s support.
”Here again, double check all information to see if and how it pertains to your specific circumstances. A qualified tax professional can look at your bigger picture and particulars that might impact how you and your children file taxes.
Frequently asked questions (FAQs)
Yes, several options exist for those who want to set up an investment account for a child. With a custodial account, the adult who sets up the account manages it on behalf of the child until the minor reaches the age of majority in your state. At that point, the beneficiary assumes control of the account. As our guide outlines, other account types exist, including options meant primarily for college savings and standard brokerage accounts where the minor owns the account and makes financial decisions with the option for adult oversight.
As Ed Mooney, financial planning director at Fiduciary Trust International detailed, “If the child works, they can open an IRA, and that IRA can be a Roth IRA, but there are limitations. If a child earns $7,000 in one year, they can potentially contribute $7,000 to a Roth IRA, but that contribution is limited if the child has significant earnings or investment income. That said, if the child has a summer job and makes a few thousand dollars, it’s probably a good idea to put money in a Roth IRA, which will, under current law, not be subject to tax while in the Roth and will not be taxed when it’s distributed after age 59 1/2.”
While you need earned income to invest in an IRA, this is not the case in a custodial account without the Roth IRA designation. If a child has a savings account or standard brokerage account, as described above, they can save and invest using cash that doesn’t come from employment.