Multi-generational family sitting at a table counting coins.

It’s easy to get stuck in short-term thinking, especially when you’re juggling life and expenses.  Wouldn’t it be nice to have a financial fairy godmother (or godfather) to grant you a few more hours in a day to focus on the long-term? While that may never happen, you can play that role for the little ones in your life.

Whether you’re celebrating a child’s birthday, a holiday or another major milestone event, here’s why investing for kids may be a gift they will appreciate when they get older.

Advantages of investing for kids

The biggest advantage of investing for your kids while they’re young is that they reap the benefits of long-term compounding.

It’s worth noting that saving isn’t the same as investing. Saving can mean putting money in an account that doesn’t earn interest (or a very minimal amount of interest).

However, if you decided to invest that same $50 a month over the course of 50 years in the stock market and earned a 6% return on your investment, they could possibly end up with more than $175,500 after 50 years.

Here are a few more advantages of investing for kids:

  • More time to weather losses: Rather than waiting until you’re older, investing early may allow you to make up for losses on your investments due to the natural ebbs and flows of the stock market. Early investing may allow your money to recover.
  • Tax benefits: 529 plans, also known as a qualified tuition plan, may offer a little more flexibility than a traditional savings account, especially if you withdraw the funds from a 529 for educational purposes. 529 plans are not subject to federal income tax on capital gains from investments.
  • Kids learn the value of money: Young children may understand the concept of money and investing if you consistently have those conversations with them. If they have a savings account, include them in discussions relating to their account and how you handle your own finances. Allow them to look over their statements and investments when you look over yours.

What is a good age to start investing for kids?

Any age is great to start a child’s investment account. They can focus on building wealth if they are exposed at an early age. Watching their money grow can excite and encourage them to save and invest more.

Types of investment accounts for kids

Let’s go over the definition of custodial accounts, custodial Roth IRAs, 529 plans and a traditional brokerage account in your name.

1.    Custodial account

A custodial account is also referred to as a Uniform Gift to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA) account. In both an UGMA or UTMA, a minor owns securities without an attorney or a trustee appointment getting involved. You can invest in a UTMA or UGMA depending on your state. You can also invest in mutual funds, ETFs, stocks, and other financial products in either a UGMA or UTMA. UGMAs hold financial products — even securitized instruments and insurance policies. UTMAs, on the other hand, can hold more, including actual property (paintings, antiques, etc.) and real estate.

You may want a custodial account because there are no contribution limits. On the other hand, the assets you give cannot be “taken back.”

And remember that there may be taxes associated with investment income generated by a custodial account, including dividends, interest, and earnings which may be classified differently under IRS rules. A tax advisor can give you a complete understanding of the tax benefits of a custodial account.

Finally, a custodial account counts as a student financial asset through the Free Application for Federal Student Aid (FAFSA). This means that you could be penalized for college financial aid.

2.    Custodial Roth IRA

​​A custodial individual retirement account (IRA) means that a parent holds money for a minor who earns income. As the parent, you’ll manage the money in the account while your children are young until the child reaches the age of majority in the state — typically age 18 or 21. When your child gets to be that age, the custodial Roth must be converted to a regular Roth IRA.

To qualify, any money your child puts into a custodial Roth IRA will have to be post-tax dollars. When your children withdraw the money in retirement, they won’t have to pay taxes on the amount they invested.

Custodial Roth IRAs are a great option because they allow your child to build up retirement savings starting at a young age tax free.

3.    529 college savings account

State-sponsored 529 plan investments grow on a tax-deferred basis and come in two types of investments: prepaid tuition plans (in which you lock in tuition rates at in-state public institutions) or a savings plan (in which you contribute to an account on a regular basis and can later use the funds at public and private schools nationwide).

529 plans allow you to pay for qualified education expenses, such as tuition, room and board, fees, books and more. You can also use the money in a 529 plan to pay for private school costs (kindergarten through 12th grade). If you make an ineligible withdrawal (such as to put a new patio on your home, for example), the IRS will deem it income and tax you. Plus, you’ll also pay a 10% penalty.

You can also switch beneficiaries, which is handy if one of your children decides not to attend college. It’s also important to remember that the money you have in a 529 could result in reduced access to federal student aid.

4.    A traditional brokerage account in your name

Opening a traditional brokerage account in your name is also an option. Brokerage accounts allow you to invest in a wide variety of investments, such as stocks, bonds, exchange-traded funds (ETFs) and mutual funds.

You can gift funds to your beneficiaries by transferring portions of your traditional brokerage account as a gift. This can be done when your kids are older and have their own brokerage accounts.

The IRS allows you to give away $16,000 in gifts in 2022, including stocks. If you gift more than $16,000, you’re subject to a gift tax. It’s a good idea to check with a tax professional about your overall tax liability.

What’s the best investment account for kids?

There are pros and cons to any type of investment account for kids. It’s important to consider your investing goals and your children’s future needs. For example, if you want your kids to use the money just for college, you may want to stick to a 529 plan. If you want your kids to have freedom to make their own decisions with their money, you may consider a custodial account, which will give them more options.

Tax benefits of investment accounts for kids

Taking the guesswork out of buying presents is a solid reason on its own to consider adding investments to your gift rotation. But gifting investments can yield another valuable benefit once the April tax filing season rolls around.

On certain types of investment accounts, such as a 529 plan, you can take advantage of tax-deferred growth and federal income tax-free withdrawals for education expenses.

  • 529 plans: You won’t pay federal tax on withdrawals, including any earnings, if you use it for qualified education expenses.
  • Custodial account: There’s no limit on the contributions or gifts you can receive. However, amounts above $16,000 per year ($32,000 for a married couple) will incur a federal gift tax.
  • Custodial Roth IRA: You don’t have to pay federal income tax on withdrawals of contributions. You can withdraw tax-free earnings once the account has been opened for five years and as long as the child reaches age 59½ or experiences a disability or buys a home.

The IRS allows you to deduct stock gifts when they’re donated to qualified charities. You can transfer holdings in your Ally Invest portfolio to a charity (note: fees are involved with this type of transfer).

Deductions are good because they lower your annual taxable income. The less income you subject to tax, the lower your tax bill (or the bigger your refund) is likely to be. In giving stocks to a charitable organization, you also get something in return (pun intended). Who can say no to that?

Stocks might not be what your recipients are expecting, or they might be a little outside-the-(gift) box for you. But once you weigh the benefits — both for the child you’re giving stocks to, as well as yourself — you might realize that putting a bow on some stocks can be the ideal gift choice.

How to open an investment account at Ally Invest

For now, you will need to open the custodial account in your name. To get started, choose between Ally Invest Self-Directed Trading, where you determine the account’s investments, and Ally Invest Robo Portfolios, where an automated platform will recommend a diversified portfolio based on your goals, risk tolerance and time frame, and provide ongoing rebalancing.

During the account opening process, you will get the option to select a custodial account as an account type.

Then, just complete the steps of setting up the account. Once your account is approved, don’t just set it, and forget it. Be sure to update your account based on your risk tolerance and life changes throughout the years. Later down the road, when the child reaches the legal age (18 or 21, depending on state law), and assumes ownership of the account, they’ll thank you for acting on their behalf. You know the drill about buying presents: something breaks, the batteries wear out, they’re put on a shelf and forgotten about or the recipient outgrows them.

Why not come up with a different type of present altogether — one that could last a lifetime? A brokerage account for kids, a 529 plan or another type of investment account for a child might be your answer.

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