Investing for Kids

Justin Gabriel |

Warren Buffett is one of the richest people in history. At age 91, he has amassed a fortune totaling well over $100 billion dollars, and donated tens of billions in additional dollars to charity.

There is no doubt that he is among the greatest investors of all time. However, his best kept secret to becoming so wealthy is not in his ability to pick stocks.

Morgan Housel is one of the most well-known financial writers around the world. His book The Psychology of Money is among the best-selling finance books of all time. In addition to being a great writer, Morgan is an avid follower of everything Buffett.

In one of his many blog posts he writes about the “secret sauce” behind the wealth creation of Warren Buffett. It’s not just that Buffett is a good investor that has made him rich. It’s that he has been a good investor for over 8 decades. This longevity, combined with the wonders of compound interest, has helped Buffett create intergenerational wealth.

Now time is certainly not the only thing that has turned Buffett into a billionaire. He is still one of the best stock pickers of all-time, and he’s been lucky a whole lot more than he’s been unlucky. Your everyday investor won’t become a billionaire. However, starting early can still offer up some pretty incredible results.

The summer months traditionally give teens their first taste at what savings can look like as they start their first jobs. The initial savings goals are typically things like their first car and planning for college. These expenses offer a great way for kids to learn about setting aside some of their money for future purposes. I would even say that these two items should be the highest savings priority for kids in high school. But if these expenses are going to be covered by outside sources, then there are a couple of additional tools that can help kids plan on a more long-term basis. In addition, as an incentive to save, parents can also “match” contributions similar to the way many company retirement plans operate.

UTMA Investing Accounts

A Uniformed Transfer to Minors Act (UTMA) account operates similar to any brokerage account, albeit with a few additional rules. Minors are not permitted to open their own brokerage / investment account, so a “custodial” arrangement is required for them to do so. Most commonly, a parent will own the account on behalf of the child, and outside of a few exceptions these assets have to stay in the account until the dependent reaches legal age – typically 18 or 21 depending on your state of residence. Once they reach that age the account is theirs to use for whatever they choose.

The custodian overseeing the account (typically a parent) has a fiduciary duty to manage the assets in an appropriate manner. This duty can extend to using the assets for health, maintenance, education, and support. As such, there is some flexibility to access the dollars should they ever be needed for things like education costs, rent, starting a business, etc.

These accounts work as a great starting point for young people to learn how investing works. When you establish these accounts, you are able to purchase everything from stocks, bonds, mutual funds, and more. This can offer a child an initial look into how saving money can lead to earning more money, which can in turn lead to earning even more. Put more simply, it gives them a view into the world of compound interest!

Furthermore, you can start to teach children that investing in stocks is not necessarily gambling. When clients establish these accounts, we will often have them work with their child to pick some publicly traded companies that they know and love. At first, this often will come down to investing in their favorite sports, games, activities, or restaurants. Companies like Disney, Apple, Dick’s Sporting Goods, or McDonald’s. But you can also help them explore business structures a little deeper. Joe from our office has kids who like Olive Garden, which is owned by Darden Restaurants, and Dairy Queen, which is owned by Berkshire Hathaway. They choose to invest in these parent companies to claim ownership in the company they really want.

This demonstrates to kids that when you invest you are actually purchasing a stake in a company where people spend money. This is turn helps a company to make money, which leads to the stock price increasing, and ultimately their money growing. However, these investments can also lose money if the stock is not performing well.

There are a few things that these accounts have that you will need to pay attention to. The first thing is that these are considered taxable accounts in the name of the child. This means that any income that is spun off from the assets owned (such as interest, dividends, or capital gains) will ultimately be taxed to them.

The IRS has something called the Kiddie Tax Rule, which allows for the first $2,300 of unearned income to be taxed at the child’s federal tax rate, which in most cases is 0%. Any unearned income after $2,300 would be taxed at the parents’ federal tax rates.

States also vary on how they tax these accounts. Minnesota, for example, will allow the first $1,100 of income to be tax free. After that threshold is reached, the child is required to file a state tax return.

For these reasons we tend to limit the amount of money that goes into these accounts. These can offer a great way for kids to learn how markets and investing work, but they can also cause a bit of a tax headache.

To help avoid a tax headache we can turn to an account that we all know and love.

Custodial Roth IRA

A Custodial Roth IRA has the same characteristics as a normal Roth IRA, except for it is again overseen by a custodian. Once the child turns 18 or 21 the account is moved into their name.

Dollars that go into a Custodial Roth IRA are after-tax dollars, grow tax-free, and can be withdrawn tax-free once they reach retirement. With the current standard deduction at $12,550 (the standard deduction is only $1,150 for a dependent), the vast majority of earned income that children have is taxed at 0%. This means you can get money into these accounts that has never been taxed and watch it grow tax free.

Because of this benefit, the tax laws make it difficult to get money into these accounts. In order to contribute to a Custodial Roth IRA your child would need to have earned income from a form of employment. In addition, the same earnings limit up to $6,000 applies. As such, if you child earns $1,000 lifeguarding this summer, then they would only be able to contribute $1,000 to this type of account. But hey, $1,000 can still grow into a big number when compounded over multiple decades!

From an investment standpoint these accounts operate in a similar manner as the UTMA accounts listed above. You can still buy individual stocks, bonds, and mutual funds using the dollars in the account.

These accounts can also offer additional flexibility for larger cash outflows during an individual’s early adult years. Contributions to the account can be taken out at any time. However, the earnings portion needs to be maintained in the account unless used for higher education, covering large medical expenses, or for a first home purchase up to $10,000.

An additional strategy we see with these accounts is getting kids used to deferring money for retirement. Much like with a 401(k) plan, you can offer up a matching component to the plan. The difference being that the matching component would come from the parent rather than the employer. The key here is to make sure combined contributions are still limited to the lower of gross earnings or $6,000.

Teaching children to save is one of the most important lessons that can be offered by a parent. The traditional route, which is to save into a savings or checking account, is still a great way to put kids on a good savings path. But to the point that kids are interested in learning how investing works, or you want to get them investing early, then these plans can offer a great avenue. At the end of the day it’s pretty unlikely they will be the next Buffett. However, they can still get the investing clock started early and turn those dollars into something pretty amazing.