How to Create an Investment Plan for Your Child

By MP Dunleavey · May 12, 2022 · 11 minute read

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How to Create an Investment Plan for Your Child

When it comes to creating financial security for your child, there are three important steps parents can take: setting up an investment account, opening a college or educational savings fund, and (as far off as it seems) laying the groundwork for a child’s future retirement with a traditional or Roth IRA.

Why think about these matters when your child is young? Because time is on your side — and theirs — and time is one of the most important factors in building lasting financial security, because time adds to money’s growth potential.

Here’s why investing for kids is important, what you can teach them, and what you need to know to get your child on the path to security and stability.

Why Invest for Your Child?

The main reason to invest early is to have more time to take advantage of compound interest and market returns.

How Compound Interest Works

Compound interest is a powerful tool. It’s essentially the interest you earn on your interest. So, for example, if you make a principal investment of $100 with a 7% annual return, after one year you’ll have $107. Without adding anything to your principal, in the second year — if rates are the same — you’ll earn the same 7% return on this new sum, bringing your total to $114.49.

In effect, each year you earn more interest on top of the interest you were already paid the year before, compounding the effect of the growth.

Different types of accounts and investments typically have different interest rates. For example, money market accounts, certificates of deposit (CDs), and other interest-bearing accounts can pay different rates. These accounts also come with different terms.

A CD, for example, may pay a higher rate than a traditional savings account, but you may have to lock up your money for a period of time ranging from a few months to a few years.

The Potential of Market Returns

When you invest your money in the market, you help your child participate in another type of growth — the potential return of the stock market, starting when they’re young. These kinds of investment gains are quite different from the accounts or securities that pay steady rates (like bonds). That’s because the stock market, also called the equity market, can be volatile. So there can be some risk involved when you put your money into stocks, mutual funds, or exchange-traded funds (ETFs).

Nonetheless, the historic average return of the market over time, even with all the ups and downs, is about 10% (that’s 6% or 7%, when taking inflation into account). That’s the average return, not the historic return every year — and that is the advantage of investing in, and staying in the market over time.

Investing for Kids

How do you get started with a basic investing account for your child? You can always open a savings account for your newborn, of course, but investing for kids has never been easier, as there are options for custodial accounts (in the parent’s name) as well as accounts your teen can manage themselves.

Custodial Brokerage and Youth Brokerage Accounts

Most young children don’t have their own income or wages. Still, you can invest on their behalf by opening a custodial brokerage account, with a brokerage firm, thanks to the Uniform Gift to Minors Act or Uniform Transfer to Minors Act (UGMA/UTMA). The account will be in your name, but can be transferred to your child once they become adults (usually between ages 18 and 25, depending on the state).

These accounts are a common way to save for college, but your child doesn’t necessarily have to use the assets to pay for school. UGMA accounts only include securities, such as stocks and bonds, whereas UTMA accounts can include other types of property, like real estate or even fine art.

There are no limits on how much money you place in a UGMA or UTMA, though parents may still want to keep the $16,000 gift tax exclusion in mind when making contributions each year.

While the parent controls assets inside custodial accounts, the money belong to the child. Parents can’t dip into the account to buy things that directly benefit themselves, nor can they transfer assets between different children’s accounts.

Income from the assets inside the account must be reported on a child’s income taxes and is subject to the child tax rate.

These accounts are taxable, and while custodial accounts don’t offer the kind of tax breaks you might get with an IRA or a Roth, there are some tax advantages. Up to $1,150 of investment earnings are not subject to federal income tax. And another $1,150 of earnings are taxed at the child’s income tax rate, which is usually lower than the parent’s tax rate.

More broadly, a custodial account is a way to establish an investment portfolio for your child, to which anyone can contribute.

How to Set Up a Custodial Account

You can set up a custodial account online, typically in a few minutes. Be sure to have basic identification information ready (e.g. dates of birth, Social Security numbers for you and your child, and possibly your employment information).

How to Set Up a Teen Brokerage Account

If you have a teenager, some brokerages offer accounts they can manage themselves. This enables young people to gain experience with choosing and potentially even trading securities like stocks or bonds, or exchange-traded funds (ETFs).

Having a basic investment portfolio may help your child understand the different types of investments, as well as important factors like risk and the long-term impact of fees, commissions, and other costs. (Who knows, maybe you’ll learn something too!)

Because investment costs vary widely, and can have a significant impact on how much an account earns over time, explaining investment costs to your child is another valuable thing you can teach them.

Ways to Invest for Your Kid’s College Education

The cost of college is overwhelming for many families. In-state tuition and fees at public universities have increased 212% in 20 years, U.S. News reported. Out-of-state tuition and fees at public schools have risen 165%. And private colleges have seen a 144% increase.

The bottom line: You’re smart to think about how to start saving for college, even if your kids are still young.

While there are a couple of different types of college funds to consider, the most versatile, for most families, is a 529 Savings Plan.

529 Savings Plan

A 529 plan, also known as qualified tuition plan, comes in two flavors: educational savings plan and prepaid tuition plans. Opening a 529 plan can have benefits for your child and possibly for you.

Educational Savings Plans

These are sponsored by different states, and allow your child to use money for tuition, fees, room and board, and other qualifying expenses at any college or university. You are not limited to colleges in the state that sponsors the plan.

You can also use up to $10,000 a year to pay for other schooling costs, before college (e.g. private high school tuition).

You can invest the 529 plan money in a variety of assets, including mutual funds, like target-date funds, which are a type of all-in-one portfolio where the balance of assets — e.g. equities vs. fixed income — adjusts based on when you expect your child to go to college.

The specific tax benefit depends on your state and the 529 plan you choose. Note that you can invest in the 529 plan sponsored by any state; you’re not restricted to the state where you live, although your home state may offer a tax break. Likewise, you can use your 529 funds to pay for educational expenses anywhere in the U.S., and even at qualified overseas institutions.

Generally, you contribute after-tax money to a 529 plan; your earnings grow tax-free, and you can withdraw the money for qualified expenses without paying taxes or penalties. If you withdraw money for anything else, you’ll pay a 10% tax penalty on earnings (and you may owe federal and/or state taxes).

Not all states offer tax benefits, so be sure to look into this when choosing your plan, as there are various ways to cover the cost of tuition.

Prepaid tuition plans

Prepaid tuition plans are quite different from a traditional 529. This type of plan allows you to prepay tuition and fees at a specific college at current prices, locking in the cost of tuition now — and potentially avoiding the higher rate when your child is ready to enroll. These plans are only available at certain universities, usually public institutions, and often require you to live in the same state. A prepaid tuition plan can save you a lot of money, given how much college costs are increasing each year.

However, if your prepaid tuition plan isn’t guaranteed by the state, you might lose money if the institution runs into financial trouble. You also run the risk that your child will choose to go to a school that’s outside the area covered by the plan.

How to Open a 529 Plan

Doing the research to select a 529 plan that offers the best options and tax breaks for your situation is the most important step, and one that will take the most time and focus. Once you’ve chosen a plan, though, the good news is that setting up a 529 plan is generally straightforward, and in most cases can be done online.

•   You will need all the basic forms of identification, as well as bank details so that you can make automatic deposits to the account, either via transfers from your checking, or via payroll deductions. Plans vary.

•   Once the account is set up, you will be able to choose from the available investment options. As noted above, these may include different types of mutual funds or even ETFs.

•   There are no income limits when contributing to a 529 plan, and anyone may deposit funds on behalf of your child (aunts, uncles, grandparents, friends, etc.).

•   The contribution limit typically varies by state; there are no specific federal contribution caps. But things can get a little sticky when it comes to the gift tax.

   If you contribute more than $16,000 in 2022 ($15,000 in 2021), it would count toward the gift tax exclusion. So if a grandparent wanted to give $16,000 to each of your children, there would be no gift tax consequences for the grandparent.

   But let’s say this is a wealthy and generous grandparent, who has given your children more than $16,000 each, in non-529 gifts, say. In that case the excess would count toward the lifetime gift exclusion, and the grandparent would have to file Form 709 to register the gifts with the IRS.

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Ways to Invest for Your Kid’s Retirement

We’ve covered a lot of ground here, and your child may not even be out of diapers yet, but there’s one more piece of your child’s investment plan to think about: their far-off retirement. Once your child is earning some income, even if it’s from babysitting or raking leaves, they would be able to contribute to a custodial IRA, either as a traditional (tax-deferred) IRA account or a Roth (after-tax) IRA account.

Bear in mind: Any person funding an IRA must have earned income, i.e. wages or tips. Unearned income, which refers to dividends and interest payments and so forth, doesn’t qualify.

Minors with earned income have to file a tax return if they make $12,950 or more in 2022. Self-employed minors must file a tax return if they earn $400 or more from their own business.

1. Custodial IRAs

If your child is considered a minor under your state law (usually under age 18), a parent or guardian must open and manage investment accounts for minor children. The custodian controls the assets in the Roth IRA or regular IRA, similar to a custodial brokerage account (described above). Once the child becomes an adult, the account may be turned over to them.

Other than that, the same rules and restrictions apply to a custodial IRA as when you open a traditional vs. a Roth IRA.

How to Open a Custodial IRA

Opening a custodial account isn’t substantially different from opening any sort of investment or bank account. The custodian opens an IRA in their child’s name. To do so, you will have to provide their Social Security number and possibly yours when you open the account.

Keep in mind, not all financial institutions do custodial IRAs.

While the parent controls assets inside custodial accounts, they irrevocably belong to the child. Parents can’t dip into them to buy things that directly benefit themselves, nor can they transfer assets between different children’s accounts. Income from the assets inside the account must be reported on a child’s income taxes and is subject to the child tax rate.

What Is a Roth vs a Traditional IRA?

Be sure to familiarize yourself with the differences between these two common types of IRAs. Basically:

•   Funds deposited in a traditional IRA are pre-tax, but the account holder pays taxes when they withdraw the money in retirement. Withdrawals before age 59 ½ may be subject to an early-withdrawal penalty.

•   A Roth IRA is funded with after-tax dollars, so the account holder does not pay taxes on withdrawals. Also, Roth IRA accounts are not subject to required minimum distributions (RMDs), which is the case with a regular IRA.

•   The contribution limit for both types of IRAs is $6,000 for 2022. You cannot contribute more than the amount your child earned. If your child earned only $3,000, say, that is the max they could deposit in a traditional or Roth IRA.

While the parental custodian can choose to fund either type of IRA on behalf of their child, the fact is that most kids won’t earn enough to benefit from the tax deduction one gets from funding a regular IRA (where the money you contribute reduces your taxable income for that year). So in many ways, funding a Roth IRA for your child makes the most sense.

2. High-Yield Savings Account

While these long-term investment options can be excellent when you’re starting to lay the groundwork for your child’s investment plan, and you have many years ahead of you, there are also short-term options.

If you think you’ll need the money you’re saving for your child in the next three to five years, consider putting it in a savings account, such as high-yield savings, which can offer higher interest rates than traditional savings accounts.

If you’re interested in a high-yield savings account, be sure to consider some of these common rules and restrictions:

•   Required Initial Deposit

   Many high-yield savings accounts require a minimum opening deposit.

•   Minimum Balance

   Some banks also require you to maintain a minimum balance to keep your high-yield savings account open.

•   Annual percentage yield (APY)

   One of the most important factors to look for in a savings account, the APY is how much you’ll earn in returns in one year.

•   Balance Caps

   A balance cap puts a limit on the amount of money you can earn interest at the high-yield account rate. So, for example, if an institution offers 3% interest on your savings account, but sets a balance cap at $2,000, you would only grow that interest on the first $2,000 and not on any additional funds you may deposit.

•   Fees

   It’s a good idea to understand what, if any, bank fees may be charged — and how you can avoid them, such as by keeping your balance above the minimum threshold or minimizing withdrawals per month.

•   Connecting With Other Accounts

   Make sure you know whether you can link your high-yield savings account and other accounts you may hold for ease of transferring funds.

How to Open a High-Yield Savings Account

Most high-yield savings accounts can be easily opened online. It will likely take 15 minutes or so if you have the forms of identification you need. This usually means your driver’s license, your Social Security number, and other bank account details (e.g. the routing number). Once signed up, you’ve entered the world of high-yield savings.

Last step: Be sure to set up an automatic transfer to the account, so that your savings begins to grow.

3. Consider Opening a CD

You might also want to consider a certificate of deposit (CD), which typically offers higher interest rates than traditional savings vehicles. The only catch with CDs is that in exchange for this higher interest rate, you essentially agree to keep your money in the CD for a set amount of time, like five years for example.

💡 Recommended: Certificate of Deposit vs. Savings Account: What You Should Know

Opening a money market account is another option that may not pay interest rates quite as high as CDs, but these accounts are generally more flexible.

While these savings vehicles don’t offer the same high rates of return you might find in the market, they are a less risky option and can give you quicker access to your money.

The Takeaway

Setting a child up for a financially healthy life is as valuable as all the other things we do for our children. Fortunately, when you start while they’re young, time is on your side and theirs: There is time for money to grow, and time for your child to learn from the steps you’re taking on their behalf.

There are three important steps you can take as a parent — none of them are complicated. The first is to set up a custodial brokerage account for your child, so they have a basic investment portfolio. You don’t have to get super creative choosing stocks or bonds; a couple of index funds will do. The next is to insure that their college or other educational training expenses are covered, by funding a 529 savings plan (these accounts typically offer a fixed menu of investments to help parents). The third is to get them on the path to a secure retirement; as soon as they have earned income they can contribute to a custodial Roth IRA.

Note that being a custodian is fairly simple: It basically means you need to open the account in your child’s name, and then manage the assets in the account until your child is no longer a minor (usually at age 18 or 21, depending on the state). Note that custodians do not have the ability to use these funds for themselves.

Another way to start investing for your child, and for yourself, is to open an Active Invest account with SoFi Invest. It’s a great way to prepare for the future. You pay no SoFi commissions or account fees, and you can set up the account quickly and easily from your phone or laptop. With a SoFi Invest account, you can buy and sell stocks, ETFs, and crypto too. Get started today.

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