Investment Accounts for Children

I frequently get asked about investment options that parents can establish for their children. It’s an important question, and there are several options available. In this article, I’ll compare and contrast some of the most popular types of investment accounts for children that parents can set up. For this exercise, I’ll focus on 529 plans, UTMA/UGMA accounts, Roth IRAs, and regular taxable brokerage accounts.

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529 Plans

First, let’s take a look at 529 plans. These are education-related savings plans that allow parents to save money for their children’s college expenses. Each state individually establishes its own 529 plan(s). Most states have two options: a prepaid tuition option, and an investment account option.

The prepaid tuition option allows parents to invest money as if tuition was due today, with the state guaranteeing that the account will cover an equal quantity of tuition expenses in the future when the child is actually incurring tuition costs. This type of account is essentially a state-guaranteed hedge against rising tuition costs. On the other hand, investment accounts are more like any other investment account where the user can select from a menu of different investment options, depending on risk preferences.

Allowed educational costs

• College tuition
• Vocational or other post-secondary tuition
• K-12 expenses up to $10,000 per year
• Fees, books, supplies
• Apprenticeship equipment
• Some student loan repayment (limitations apply)

529 plans can have several tax benefits. The money in the account grows tax-free and you can withdraw funds tax-free for qualified educational expenses, such as tuition, fees, books, and room and board. Additionally, in most states contributions to 529 plans can be tax-deductible for state taxes.

However, 529 plans have a few drawbacks. First, you must use the money in the account for educational expenses. If you withdraw money sooner, or for non-education expenses, it will likely be subject to taxes and a 10% penalty. Additionally, 529 plans are not flexible; you are generally limited to the investments available in the plan, which may not meet your investment goals.

UTMA and UGMA Accounts

Another type of investment account for children has been established by the Uniform Transfers to Minors Act and the Uniform Gifts to Minors Act. I’ll refer to this type of account as a UTMA / UGMA account. This type of account is a custodial account that allows parents to save and invest money on behalf of their children.

The money in this account is held in the child’s name, but the parent is the custodian of the account until the child reaches the age of majority (usually 18 to 25, depending on the state). The transfers into the account are irrevocable. Parents can use UTMA/UGMA accounts to save for college. But the accounts are equally appropriate for other expenses, such as a car or a down payment on a house.

Unlike a 529 plan, the money earned in this type of account is not tax-free; instead, contributions to these accounts are made with after-tax money, and any earnings are taxed at the child’s tax rate. There is a small tax benefit to UTMA/UGMA accounts, however, in that the applicable tax rate is generally the child’s, which is usually lower than the parents’. Consult with a tax professional for more guidance.

I recommend parents use a UTMA rather than a UGMA account. The accounts are very similar, but a UTMA account is slightly more flexible. A UTMA account can hold non-standard assets like art, and it also has some flexibility around the age of majority for the child. But, for most purposes, a UGMA account is just as good, so don’t fret if that’s what you already have.

Roth IRAs

Parents can also set up a Roth IRA for their children. This type of account is an individual retirement account that allows for tax-free growth of investments. Unlike a 529 plan, this type of account is not specifically designed for college savings; instead, it is designed to help individuals save for retirement. You fund a child’s Roth IRA with after-tax money. But, the earnings grow tax-free and withdrawals are also tax-free.

However, to set up a Roth IRA for a child, the child must have some earned income. And, you can’t contribute more than the child has earned that year. So these accounts are more appropriate for older kids, who might already have some income from babysitting, etc. Investors should consult with a tax professional first, as setting up a Roth IRA for a child might require some recordkeeping for the child’s income that normally could be safely ignored.

Taxable Brokerage Accounts

Finally, there are taxable brokerage accounts. These are investment accounts that allow parents to save money for their children’s future. The money in the account grows without any sort of tax benefit, so interest income, dividends, and realized capital gains are subject to the usual taxes.

Gift Tax Concerns

All of the options above may be subject to IRS gift tax rules. These rules are complicated and require the advice of a tax professional. There are many aspects to managing gift tax, but I’ll just note one here that there is generally an annual exclusion from gift taxes. In 2022, this exclusion was up to $16,000 per child, and in 2023, it is $17,000.

Estate Planning Concerns

In addition, it’s important to consider estate planning factors when deciding which type of account to use. Investment accounts for children are basically an inter-generational wealth transfer. You should use them in coordination with an overall estate planning strategy. If you already have an estate planning strategy, use that to guide your investment account selection for your children. If you don’t, consider consulting with an estate planner before you establish investment accounts for children.

Conclusion

There are a lot of options here. Don’t let that dissuade you from setting your children up for success. Invest in their future! Don’t worry about selecting the wrong type of account. Just remember that having no account is the worst option!

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