Why Open an Account for a Child to Invest

We talked in a previous post, Compounding and the Power of Starting Early, that when you invest early you don’t need to save much to reach a large sum by the age of 65.  One of the best things you can do for your kids or grandkids is to start early and allow the wealth to compound over a long period of time.  It could be a financial legacy you leave for your family.  Some people grow a large family tree.  You can grow family wealth just by starting early and invest money for your kids.

Let’s Get Started

First of all, what I am suggesting is in addition to college savings, using 529 accounts.  Definitely invest in your kid’s college by opening a 529 account for them.

Second, I am not talking about opening a savings account at a bank.  We all know that a savings account at most banks will earn less than 1%.  Some online banks like Ally can earn around 2%, but that is still too low for what we are trying to achieve.  We want 5-10% return on investment and we can afford to be aggressive.  So we could invest in a S&P Index fund or higher yielding dividend stocks.  But we getting ahead of ourselves, let’s first talk about what kind of account.

Types of Accounts

There are a lot of options:

• A Uniform Gift to Minors Act (UGMA) account at a brokerage like Fidelity or Vanguard.  This is also called a custodial account.
• A Roth IRA in the minor’s name.
• A trust fund set up for the minor or family members.
• A brokerage account in your name but with the child listed as a beneficiary.

Where Should You Invest

Probably the simplest approach is to open an account with Fidelity or Vanguard.  I already have accounts at Fidelity so I found it easy to use that investment company.  Fidelity has no minimum for setting up a brokerage account.  Fidelity has several 0% expense ratio mutual funds, and they have funds with low expense ratios and no minimum amount to invest. You will be charged for equity trades, currently at $4.95 per trade at Fidelity, and there are other fees that may come into play.  You should always investigate the expense ratio fees of any mutual funds you invest in, and both Vanguard and Fidelity have low expense ratio funds.

Recently I opened an account on RobinHood and learned that RobinHood has no way to specify beneficiaries or create a joint account.  Hence, I would not recommend using RobinHood for this type of account.

Make sure that wherever you invest the company supports basic functionality such as custodial accounts, Roth IRAs, beneficiaries (Transfer on Death), easy transfer of money, no account charges, and low expense ratios.

UGMA Account

The simplest thing to do is go to fidelity.com and open a UGMA Custodial Account.  This is essentially a brokerage account with the child’s social security number but you control the account until the child reaches legal age.  You can then setup the ability to transfer money into the account.  Once the account has a cash balance, you can start investing.  Keep in mind you have a long horizon, so keep the trading to a minimum.  Don’t treat it like your day trading account, because you have fiduciary responsibility to manage the money in the best interests of your child.

A custodial account requires either the parent or the child to pay taxes.  See the Investopedia Article on UGMA for details.

Roth IRA

The Roth IRA is well known as one of the best retirement mechanisms we have available to us.  Once the kid has Earned Income, you can start putting money into this account for your child up to the maximum allowed for an IRA or the maximum earned by the child.  Again Fidelity has good information to get you started.

The advantage of a Roth IRA over a brokerage account is the tax treatment of capital gains.  The money can grow more in this account since you already paid taxes on the earned income.

Trust Funds

Setting up a trust fund is another option.  The primary advantage is the control of the trust fund by the trustee.  Taxes are paid by the trust.  Investopedia has a good article on Trust Funds but you will need to see a lawyer to set up a trust and at that time, you can discuss the options and costs.

Brokerage Account With Child as a Beneficiary

You probably have your 401Ks, IRAs, and brokerage accounts set up with your family as beneficiaries.  You can create a brokerage account just for your kids and list only them as the beneficiaries.  This has the advantage of you being in control, but you also have to pay taxes on capital gains and dividends or interest.  Fidelity has an article on Inheritance that gives details on taxes on inherited accounts.