You likely already know the importance of investing for retirement, and you want to pass that knowledge along to your children.
Without the growth provided by long-term investing, most people would find it nearly impossible to grow the nest egg they need to be financially independent in later years. And as hard as contributing to a retirement account can be for investors, your children face an even steeper road to climb to financial independence than you do.
“Inflation over the last 100 years has devalued the dollar and will continue to do so, meaning children today will need a great many more dollars in the future to live on than what we do today,” says Mark Charnet, founder and CEO of American Prosperity Group in Pompton Plains, New Jersey. For instance, it takes $10,000 today to buy the same amount of goods you could have bought for $5,834 in 2000, according to the U.S. Bureau of Labor Statistics.
One of the best ways to combat the impact of inflation is by investing. The earlier you start investing, the better off you’ll be. Here are some advantages to opening a brokerage account for your kids and the steps to follow to get them started on the right foot:
— Why you should open a brokerage account for your kids.
— Types of brokerage accounts for your kids.
— How to decide on a brokerage firm.
Why You Should Open a Brokerage Account for Your Kids
“Often referred to as a turbocharge or super-boost, the earlier one starts investing, the more time for compounding’s exponential growth to occur,” says Thomas O’Connor, senior wealth advisor at Keel Point in Huntsville, Alabama. The corollary to this is: The earlier you start investing, the less money you’ll actually need to invest to reach a given goal.
A person who starts investing $200 per month at age 25 can stop investing at age 35 and still have more money come retirement at age 65 than someone who invests $200 every month from age 35 to age 65. Translation: Investing $24,000 between age 25 to 35 results in more in the long term than investing $72,000 from age 35 to 65.
Opening a brokerage account for your child could give them a big head start in life. In addition to helping provide your children with future financial stability, investing on your children’s behalf can also yield other benefits.
“A brokerage is a great way to start an investment dialogue with your child,” says Pam Lucina, chief fiduciary officer at Northern Trust Wealth Management. “Funding it with a small amount and working with your children to select investments provides them with real-life financial literacy.”
You could let your children pick a few investments and ride out the market volatility to provide an experiential learning opportunity.
“Your child will be learning the value of compounding interest, about different types of investments, the power of diversification and how to interpret a brokerage statement,” Lucina says. “As they age, ask them to seek out new investments and provide a recommendation to you as a way to hone their research and deductive reasoning skills.”
Types of Brokerage Accounts for Your Kids
“There are a myriad of options when investing for your children,” Charnet says. In fact, the options are largely the same as the ones you have when investing for yourself.
You can open the following types of brokerage accounts for your kids:
— 529 college savings account.
— Roth IRA.
— Traditional brokerage account in your name.
529 college savings account. If you’re investing for a child’s education, you might use a state-specific 529 account. These allow you to make after-tax contributions to an investment account that can later be used tax-free for qualifying primary or secondary education expenses.
“The primary downfall of a 529 plan is that the funds must be used for educational purposes in the future, and your child may decide not to pursue a higher education,” Charnet says. “You can transfer the account from child to child for educational purposes, or face penalties and taxes if you use the funds for non-educational reasons.”
The ability to pass 529s down makes them “exceptional legacy accounts, as they can be passed down indefinitely with tax-free benefits for education needs,” O’Connor says.
Roth IRA. If you want to give your children a leg up on retirement, you could open a minor Roth IRA. “If you think compounding is impressive, tax-free compounding is on another level,” O’Connor says. There’s one catch — to use a minor Roth IRA, your child must have earned income and you can only contribute as much as they earn in the year up to the annual maximum, which is $6,000 for 2022. So if they earned $1,000 working as a camp counselor, you could put $1,000 into their Roth IRA.
Contributions can be withdrawn tax-free, although there are income taxes and a 10% penalty if your child withdraws investment earnings before age 59 1/2. However, there are exceptions: The IRS will let your child withdraw up to $10,000 of earnings for a first-home purchase without paying the penalty, and if the account has been funded for more than five years, those earnings are tax-free as well.
Custodial account. For a general-purpose investment account for your child, consider a custodial account, such as a Uniform Transfer to Minors Act account, or UTMA, or a Uniform Gifts to Minors account, or UGMA.
“Similar to an individual brokerage account, you may be subject to taxes each year depending on dividends and capital gains,” O’Connor says. “However, with a UTMA, taxes are at the child’s tax rate, which is generally less than the parent’s.” Unearned income over $2,200 will be taxed at the parent’s rate.
Custodial accounts are in the child’s name, but you as the parent retain control over the investments and withdrawals until the child reaches the age of majority in your state, which is usually between 18 and 25. “Once they reach the age of majority, then the child automatically gains control of the account, which is a con that we point out to clients from a control standpoint,” says Daniel Milan, managing partner of Cornerstone Financial Services LLC in Southfield, Michigan.
It’s also possible for your child to sue you for mismanagement of their UTMA account, Charnet says.
Traditional brokerage account in your name. If these are concerns for you, then a better option may be to open a brokerage account in your name and earmark the funds for your child. You’ll have to pay taxes at your tax rates, but you’ll also retain full control over the account and face fewer restrictions than with any of the previously listed options.
Once you decide your child is mature enough to take over the account, you can retitle it in the child’s name, Milan says.
“Children can also be named successors in the event of the parent’s incapacity or death, and the account can be transferred to the child if the assets are placed in a trust or will by the parents,” Charnet says.
How to Decide on a Brokerage Firm
Once you decide what type of account is best for your kid’s situation, the next step is to choose a financial firm where you’ll open the account.
A large custodian may be a good choice. Firms such as Fidelity, Charles Schwab or Vanguard can help you with any account you choose. Simply Google “start a Fidelity brokerage account,” and you’ll find a link to the firm’s website, where you can see the different account types. From there, just follow the steps to open a new account.
Depending on the account type, you may need to provide your child’s Social Security number as well as birthday and contact information, in addition to your own.
If you’d like help, you can also work with a financial advisor, who can walk you through the steps.
You can usually fund your account with a paper check or bank transfer, then it’s time to start investing.
You can get a little more buy-in with the process by investing in companies your child likes, O’Connor says. But while this strategy may stoke engagement, it’s also important to teach your kid about diversification, or not placing all your eggs in one basket. You can do this by adding broadly diversified exchange-traded funds, or ETFs, and mutual funds that will give you access to a basket of securities with each share you buy.
“With funds, you get ease of use, professional management, stated investment objectives, small minimum investment requirements, low costs and fees of operations, and the ability to transfer your funds between other funds in the same family without additional fees or expenses,” Charnet says. “Different funds have different investment objectives, so read and compare.” A fund’s investment objective can be found on its profile page.
“Any reputable brokerage firm will let you open more than one account, which means you should have one for each child,” Charnet adds.
As your child grows, you can involve him or her in investment decisions and management. “By involving your kids in these financial matters at a young age, you can put them on a better path toward confidence and competency in managing their finances in the future,” Lucina says.
More from U.S. News
Update 09/15/22: This story was previously published at an earlier date and has been updated with new information.