ALEXANDRIA, VA (Sept. 21, 1998) --There are many positive aspects of DRP investing, and even a few that are somewhat negative, as Jeff described here a while back. Today I'm going to talk about one of the most endearing facets of DRPing to me, which is the ability to get our youth involved in investing at a very early age.
Imagine the excitement on young Johnny's face when he rips open his birthday present and finds a crisp new stock certificate inside! (The crying usually stops after about two and a half weeks, really.) While it might not be the "Super Metamorphosing Toxic Iguana from Outer Space" action figure that Johnny has been dreaming about, it is perhaps the most important gift he could receive. Exposure to the stock market and learning how to save for one's future comes way too late in most of our lives. Johnny may not be coloring you any masterpieces to post on your fridge soon after this offering, but someday he may be buying you a Picasso. Well, he'll most likely be thankful, anyway.
Ah yes, kids and DRPs. They go together like Abercrombie & Fitch. It doesn't take much money to set up a DRP, and contributions can be made as low as $10 for many fine companies, making it easy for you to give the gift that keeps on giving. But there are some decisions to make and things to know before plunging in.
Most of you are aware that minors in most (if not all) states cannot own securities outright. Instead, a guardian or custodial account must be established. The basic difference between the two is that of ownership. In a guardian account, the guardian retains ownership of the funds and is consequentially responsible for taxes on earnings. The guardian can also withdraw the money at any time for any purpose.
Conversely, the child is the owner in a custodial account. The parent or custodian will have control over the transactions in the account, but ownership remains with the child. Earnings will be taxed at the child's rate up to a limit. Custodial accounts are easier to set up and usually make more sense due to the inherent tax benefits.
UTMA accounts are similar to UGMA accounts, except that UTMA accounts allow the guardian to maintain control over the money for a longer period of time (until age 18, 21, or 25, depending upon the state). UGMA money is available to the child at the age of majority. In these accounts only the first $1,000 of income will be taxed at the child's rate if the child is under 14 years of age. Income above $1,000 is taxed at the donor's rate. When the child turns 14, income from the trust is taxed at the child's rate. Donors may contribute up to $10,000 annually ($20,000 with a joint gift) into a Uniform account without incurring a gift tax consequence. For tax purposes, the donor and custodian should not be the same person.
Okay, all that's fine and dandy, you say, but how does one go about setting up such an account? Uniform gift accounts are a breeze. Register the account, DRP or otherwise, with the child's social security number and indicate the name of the custodian and child as such: Gardner Barnes, Custodian for Johnny Barnes under the (your state) UGMA.
One thing to keep in mind with gift accounts is that they will count as assets when the child applies for student financial aid, whether in the form of grants or loans. Colleges and financial scholarships generally assume that 35% of assets in a child's name be used to pay tuition before calculating any award of financial need. This figure is approximately 6% of assets for parents' assets.
It's also worth mentioning that once the child gains control over the account, it's theirs to do with as they wish. They may decide to buy a Harley Hawg and tour Nova Scotia or sink that moola into a lifetime supply of Jelly Bellys.
An alternative to gifts to minors would be the new Educational IRA. An Educational IRA allows you to invest up to $500 a year for each child younger than 18, depending on your income. If you're single and your income is less that $95,000, you can contribute the full $500 per year. The contribution limit gradually falls as your income climbs toward $110,000, at which point you can't contribute. For married couples filing jointly, the income limit range spans from $150,000 to $160,000.
Earnings on Education IRA contributions grow tax-free. You can't deduct contributions, but when you withdraw funds, you pay no taxes or withdrawal penalties on them if they're used for qualified higher-education expenses before the beneficiary reaches age 30. If you don't meet these requirements, you'll pay taxes on the earnings, plus an additional 10% penalty. You may, however, roll over any unused funds to an Educational IRA for another child.
For Educational IRAs, you must designate the child as beneficiary, and you can make contributions only until the beneficiary turns 18. Friends and relatives can also contribute, provided the total amount invested per child doesn't exceed $500 per year.
Not many DRPs offer the Educational IRA as an option at this time, but the number is growing fast.
If the restrictions and ramifications of the accounts we've talked about tonight sound like they may outweigh the benefits in your particular situation, please don't let that stop you. If all else fails, you can always set up a separate account in the child's parents' names for the child's benefit. The important thing is getting started early and helping those that you care about learn to save early and often, avoid debt, and secure a less worrisome future. In other words, teach them to be Foolish! Finally, as always, if you have questions please visit the message boards linked in the top right of this page.
Have a great night!
More from The Motley Fool
This Is Americans' No. 1 Financial Concern for 2018
Hint: It's not about savings.
Got a Raise? Make the Most of It With These 4 Tips
You could increase the value of your raise many times over.
2 Reasons to Buy Zoe’s Kitchen, 1 Reason to Wait
The fast-casual restaurant chain might be on the verge of a comeback.