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UTMAs, 529s, IRAs, and other investing options for kids

I’m old enough to remember gifts from the generation that lived through the Great Depression. In the 80s, “something for your future” might mean savings bonds or gold coins, safe assets to be sure, but not the kind that might grow to cover tuition or a down payment on a house. Today’s families have a multitude of options for structured investment plans that benefit the youngest generation. Trusts can be filed online, brokerages offer UTMA accounts, and state governments provide 529 plans for education. Parents can even assist in opening IRAs for children that have income from part-time jobs, perhaps in family businesses. Choosing the right plan will depend on your financial resources, the value you place on liquidity, and family members’ individual personalities.

UTMA accounts
The simplest, most flexible accounts to open for children are called UTMA (for the Uniform Transfers to Minors Act of 1986). These accounts are an alternative to trusts without all of the legal paperwork, but with some of the same asset protection. A UTMA can receive assets from anyone, with $15k per year per donor exempt from gift tax. It can invest in stocks and bonds through a brokerage account, as well as own real estate, gold, royalties, and intellectual property. The assets go to the beneficiary at age 21 in most states, but if the guardian is also a donor, the assets are included in their estate if they die before such transfer. As for taxes, the first $1050 in investment income each year is exempt, with the next $1050 at the child’s rate. After that, the guardian’s rate takes effect.

529 Plans
When it comes to taxes, 529 education savings plans have an advantage. Contributions are not deductible from parents’ income, but once invested they grow tax-free, and there is no tax on qualified withdrawals for K-12 or college expenses. The drawback of these plans is that investment options are limited. You can’t open a 529 account with your brokerage, but must choose a state program (out-of-state investors are welcome), and you are restricted to that state’s choice of administrator and mutual funds. If you expect traditional stock portfolios to do well during the investment period (for an 8-year-old today, we wouldn’t), and you are sure that the funds will be used for education, 529 plans may be a good option. As for asset protection, these funds are not protected from parents’ creditors.

Trusts
Trusts come with complexity, legal expenses, and tax disadvantages, but they offer the most flexibility and security. When assets are substantial or family situations tricky, it makes sense to have an attorney craft a custom solution. As for investment options, trusts can access all manner of assets, and may even take out loans to buy property. Just remember that taxation is more onerous than for individuals.

IRAs for kids?
If children of any age have reportable income, they can contribute all of it, up to $6000, into an IRA to grow tax-free for their retirement. Half a century of compounding will do wonders for these accounts. For example, $6000 contributed each year from age 16 to 18 would grow to $300k by age 65, without any further contributions, assuming a 6% compound return (the historical after-inflation return on equities). Kids don’t actually need to save up $6000 to max out their IRAs, but only need to earn $6000. Parents or anyone else can gift them the full contribution. Kids should open Roth IRAs, rather than Traditional, because contributions to Roths are considered “after-tax” even if the holder is in the 0% tax bracket (up to 12k) and are not subject to income tax in retirement.

Encourage your kids to take on some kind of paying work as soon as they are legally able. Federal and local laws regulate what kinds of work are allowed by age. Under 14, these are only baby-sitting, newspaper delivery, acting, modeling, and making Christmas wreaths, specifically “evergreen wreaths.” At 14-15, kids can work in retail, food service, life guarding, and perform some manual labor, although hours are restricted during the school year. At 16, there are few prohibitions other than especially hazardous jobs like coal mining, and at 18 pretty much everything is allowed.

Family businesses
The sooner your kids start working and saving, the less they will need to save overall, and what better way than while learning a family business? Such fortunate families can even reduce their overall tax burden, as any children employed will likely be in a low bracket (0% up to 12k), and their salaries will reduce the income taxed at higher rates. Wholly-owned family businesses are also largely exempted from child labor restrictions, so even a 12-year-old might help with data entry or managing social media accounts. If you go this route, make sure the work and rate of pay are legitimate, document everything, pay into kids’ bank accounts (not with hard cash), and file W2s and other tax forms. Definitely research the law and plan everything with an accountant.

Teach your kids about investing early
While we wouldn’t advise anyone to pick stocks, it worked for Warren Buffett at 12. More realistically, setting up an account for your kids should spur them to learn about different kinds of assets and to think far into the future. Most kids will have a higher time preference than famously patient Warren, but if they are going to make mistakes, better sooner than later. And if a child proves especially ill-suited to handling money, learning this about them early on may prompt you to set up gates and incentives through a trust or other plan, rather than hand over a chunk too early in life, as you might with a UTMA.

As for outright gifts, parents with cash to spare should at least make sure that everyone who works is maxing out their IRA each year, even into adulthood. As we discussed last month, gifts up to $15k per year ($30k from married couples) do not eat into the $11m estate tax exemption.  So long as the cash is invested for the future, why not help stuff everyone’s investment accounts?

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