Investing for Your Kids
The Non-IRA Option
Investing for Your Kids
You've had your eye on that great, brand-name, long-term stock which you now feel sure is undervalued and which, over the years, you're confident will appreciate many times over.
You decide to buy your first passel of shares, and your thought is that these shares will be for your children. Further, you decide (let's say) that you'll make it a DRP stock -- that way, you can contribute $50 a month, without ever having to worry about commissions.
You're poised to take action. Your quavering hand reaches for the telephone. But wait!
Let us pop the big question (no, we're not asking you to marry us!): Should you open the account in your child's name, or in your own? If you open it in your child's name, can it be (should it be?) an IRA account?
Remember that, in order to qualify for a traditional or a Roth IRA, the account holder must have earned income. If we assume for the moment that we're talking about young children, and that they have no earned income, they can't have an IRA in their own name.
So the next decision is: If this isn't going to be an IRA account, does it matter if it's in your name, or your child's name? Are there tax consequences one way or the other?
The answer is yes, it does matter, and yes, there are tax consequences.
Once again, remember that you can have either a guardian account or a custodian account for your child -- neither of which need be an IRA. Having a guardian account is essentially the same thing as having your own account -- it's in your name, it's your money, it will be taxed at your tax rate, and you will have control over it. It's the same thing as if you say to yourself, "Well, I'm going to take 50 of my shares of HighFlyers Inc., and 50 of my Lo-Fat Dogmeat Inc., shares, and I'm going to withdraw those hundred shares for Buffy's education when she turns 18. I'll earmark them myself, and no one in the world needs to know that but me." What a guardian account does, though, is formalize that agreement with yourself.
What of the custodian account? It has certain tax advantages along the way. If your child is under age 14, then the first $650 per year of dividends or capital gains are tax-free; the second $650 are taxed at the child's rate (generally 15%). Anything beyond that is taxed at your (the parent's) rate. This means that if, say, you've invested in a company whose stock pays dividends, then you're getting some tax shelter each year. If you've invested in a growth stock, one that doesn't pay dividends and which you're holding for the long term, you're not really gaining a whole lot, since you're not getting sheltered income each year.
If your child is age 14 or older, and we are only dealing with unearned income (not wages), then the first $650 is not taxable, and any amount over $650 will be taxed at your child's rate. Period. There will be NO tax at your (the parent's) rate -- no matter how much your child earns. This is one of the things that makes the UTMA/UGMA accounts so appealing. If you're in the 39.6% tax bracket, but your child (over age 13) is only in the 15% tax bracket (up to income of about $24,000), the tax savings can be enormous -- especially when you take those tax savings over a number of years, while interest is compounding.
There's also something to be said for the psychological factor. If you're like most people, you'll find it helpful to see in black-and-white, on the statement from your broker, that this account is actually earmarked for your child. Sure, you may have been able to keep that fact in your head, and you may even have been able to honor it ("Yes! I know that this 7% of my portfolio actually belongs to Buffy!"), but actually seeing Buffy's name on the piece of paper can help to solidify things.
One other point needs to be made both about UGMA/UTMA accounts and IRA accounts: their potential impact on financial aid for your child in later years. Because money held in your child's name is given more weight than your money by those determining financial aid for college, your child may have a tougher time qualifying for such aid. This is considered by some to be one of the major drawbacks to an UGMA/UTMA account.
One counter-argument is this: Why limit your child's potential to attend only a school that will provide financial aid? Better to save as much as you can for them, with the best possible tax situation, in order to give you both as much flexibility as possible.
A Word About Trusts
For people in certain situations -- such as those who're fortunate enough to have sufficient resources that they're concerned about estate taxes -- a straight trust can be superior to any type of custodial/guardian account. The reason is that a trust removes estate tax issues from the picture completely.
This is, in general, not a "do it yourself" arrangement, as you're then dealing with complex interrelated income tax and estate tax issues -- you're going to need a qualified, paid professional's help. While it isn't the purpose of this collection of articles to delve deeply into the nature of trusts, we feel that it deserves a mention.
All righty then. The next question is: What can I put into this account?