The 3 Best Investment Accounts for Kids

The 3 Best Investment Accounts for Kids

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In today's world, planning for the financial future of your children or grandchildren is more important than ever. As a certified financial planner, I've had a few friends and family members recently ask me about the best ways to invest for their kids' futures. It's makes me so happy to hear these questions being asked so early, as starting to invest early can have a huge impact on what’s available for them in the future. 

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In this post, I'll discuss three investment account options: 529 plans, custodial Roth IRAs, and UTMA accounts. We'll explore the pros and cons of each, along with their tax advantages, to help you decide which is best for you and your family's situation.

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1. The 529 Education Savings Plan

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A 529 plan is a tax-advantaged savings account designed specifically for education expenses. The primary benefit of a 529 plan is that the interest, dividends, and capital gains accumulate tax-free, meaning no taxes are owed as they accrue each year, allowing 100% of the balance to compound. Withdrawals are also tax-free as long as the funds are used for qualified education expenses.

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Pros:
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• Tax Advantages: Earnings grow tax-free, and withdrawals used for qualified education expenses are also tax-free.
• State Tax Benefits: Some states offer tax deductions or credits for contributions to a 529 plan.
• Wide Range of Uses: Funds can be used for tuition, fees, room and board, books, supplies, vocational and trade schools, apprenticeships, and even K-12 schooling (up to $10,000) and student loan repayment (up to $10,000).
• High Contribution Limits: While there are no federal contribution limits, most states cap total contributions at around $300,000.
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Cons:
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• Penalties for Non-Education Use: Withdrawals not used for qualified education expenses are subject to income tax and a 10% penalty on the earnings.
• No Federal Tax Deduction: Contributions are not deductible on your federal tax return.
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529 plans allow for lump-sum contributions by front-loading up to five years' worth of contributions, which can significantly boost growth due to compounding. For example, contributing $2,000 upfront and $100 per month for 18 years at a 7% return can grow to over $50,000. Doubling the monthly contribution to $200 can nearly double the savings to over $93,000.
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2. Custodial Roth IRA
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A custodial Roth IRA is a retirement account set up for minors, where an adult serves as the custodian. This account offers tax-free growth and withdrawals in retirement, similar to a regular Roth IRA. However, the minor must have earned income to contribute.
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Pros:
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• Tax-Free Growth: Contributions grow tax-free, and qualified withdrawals in retirement are also tax-free.
• Flexibility for Early Withdrawals: Contributions (but not earnings) can be withdrawn anytime without penalty. Certain qualified withdrawals (e.g., for a first-time home purchase or education expenses) can be penalty-free but are still taxable.
• Retirement Savings Kickstart: Starting early with a Roth IRA can significantly benefit from compound interest over decades.
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Cons:
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• Earned Income Requirement: Contributions are limited to the lesser of $7,000 (2024) or the minor’s earned income for the year.
• Long-Term Commitment: The primary goal is retirement savings, so funds should ideally remain untouched until retirement.
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This account can be an excellent tool to instill the value of long-term investing in your children. Even if a child earns a modest income from part-time work, contributing to a Roth IRA can set them on a strong financial path.
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3. UTMA Accounts (Uniform Transfers to Minors Act)
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A UTMA account is a custodial brokerage account where the minor is the beneficiary. The custodian manages the account until the minor reaches adulthood, at which point they gain full control over the funds.
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Pros:
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• No Contribution Limits: There are no annual contribution limits, making it flexible for significant gifts.
• No Restrictions on Fund Use: Funds can be used for any purpose once the minor reaches adulthood.
• Simple Setup: Setting up a UTMA account is straightforward, with fewer regulations than other accounts.
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Cons:
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• Taxable Earnings: Interest, dividends, and capital gains are subject to taxes annually.
• Ownership Transfer: Once the minor reaches the age of majority (18-25, depending on the state), they gain full control of the account, which can be a drawback if they are not financially responsible.
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UTMA accounts provide flexibility, as there are no specific requirements for how the funds must be used. However, the lack of tax advantages compared to 529 plans and Roth IRAs means that ongoing taxes on earnings can reduce the overall growth of the investment.
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Combining Investment Strategies
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It's important to note that you don't have to choose just one type of account. Many families benefit from a diversified approach, using multiple accounts to achieve different goals. For example, you might use a 529 plan for education expenses, a custodial Roth IRA for long-term retirement savings, and a UTMA account for more flexible financial needs.
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Conclusion
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Investing for your child's or grandchild's future is a wise and forward-thinking decision. Each account type—529 plans, custodial Roth IRAs, and UTMA accounts—offers unique benefits and considerations. By understanding these options and how they can complement each other, you can create a financial plan tailored to your family's needs.
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Remember, the sooner you start, the more time you have for your investments to grow and secure a brighter future for your loved ones.

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