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Ask The Readers: Investing for Kids?

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A little more than a year ago, I wrote an article about whether or not to invest our babies' money. The advice was overwhelming. Since they aren't going to use this money (mostly birthday cash from relatives/friends) for quite some time, it should be invested on their behalf.

invest baby money

Look at all this money!

Unfortunately, I lived down to my Lazy name. I didn't invest the money. On the bright side, they probably haven't lost any money as I would have split it between domestic and foreign stocks. The domestic portion would have done well and the foreign, not so well.

It's time to fix that. I'd like to set-up a brokerage account for them. Even a year later, at ages 1 and 2 they won't be needing the money for years. I called up USAA with a very simple plan: open up a brokerage account in each of their names, transfer their money into, buy an ETF, and watch it grow over the years.

Bad plan.

Since they are under the age of 18, I can't open an account in their name. That makes legal sense, but I didn't anticipate it. It appears that there are two options:

  1. Open two brokerage accounts in my name. In this case I'd manage them as if they were my own.
  2. Open a UGMA/UTMA account for each of them. In this case, there's some special tax treatment that I'd have to understand.

So let's look at the two:

Brokerage Accounts in my Name

It doesn't feel right to have the money in my name. It's their money.

From a financial perspective, this money should be taxed at their income levels... which would be significantly less than mine even in the future.

Pros and Cons of the UGMA/UTMA

Evan from My Journey to Millions highlights some of the problems with UGMA/UTMA accounts:

1. When it comes time to calculate financial aid, it's going to show up as their money.
2. The children receive the money at age 18 or 21 (depending on the state).

I don't have a problem with either of these. The money should show up as theirs when it comes to financial aid. I don't care if they spend it before the age of 18 or 21. In fact, I'm hopeful it will grow to be enough to buy a car at age 16. Then they can say, "Hey, good job investing my money when I was 2, Dad!" (I won't hold my breath on that one.)

What I have a problem with is that a significant portion could be taxed at the parents' marginal tax rate. Reading this this tax codes makes my head explode. As I understand it, this was prevent a loophole where parents were using this to shelter their money.

I don't think money that was gifted to them by friends and relatives should be subject to our tax rate, but it seems like it is.

So What Should I do?

I don't know if this is an answer to my own question, but I'm thinking that this whole issue may be a moot point. I intend to buy an ETF in the brokerage and hold it for a long, long time. I think that would qualify it as a long-term capital gain and not subject to marginal tax rates.

It makes me think that I should just open the brokerage account in my name and manage it myself. Just to be sure a call to my tax advisor may be of help.

In case you were wondering, I'm thinking of buying Vanguard Total World (VT) as my one stock for them. The reason is that this provides great growth potential and diversity (in a domestic and foreign sense) with minimal risk (due to the long-term outlook). Also, since they don't have a lot of money to invest, I want to keep the brokerage commissions at a minimum (a $10 commission is 1% of a $1000 balance). That rules out buying a portfolio of stocks.

So what do you think? Let me know in the comments below.

Posted on August 19, 2015.

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Investing, Kids

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15 Responses to “Ask The Readers: Investing for Kids?”

  1. Steve says:

    Isn’t there some amount of money that can be in their name without triggering the kiddie tax?

    • Lazy Man says:

      There is. This is one of the details that I didn’t want to get too far into because I don’t really understand it. It looks like the first $1900 (it adjusts) is exempt. However, in 16 years of compounding, it could easily be more than that. Now if they can pull out that much per year, that might be interesting.

  2. Revanche says:

    Well, ok, now my head wishes to explode. I was trying to figure out where to stash money for LB as well since the gifts that are for hir are currently sitting in a bank account under our names until I get there.

    Right now, I’m leaning toward investing at least part of the money that we’re saving ourselves for hir in a 529 savings plan and the gifts in a brokerage account. The tax implications of investing in our names while ze is a minor are complicated enough that I’m not sure it’s worth the effort of untangling that ourselves, or it might be worth a consultation with someone who knows taxes more than we do.

  3. Steve says:

    I believe it’s $1900 per year in investment income. That would actually mean that your suggestion to make everything a LTCG might not help; if the investments are sold and the income recognized while the kid is still a minor, it would basically “save up” years of income into one fell, greater than $1900 swoop. You could always do some tax-gain harvesting up to $1900 per year, but how much effort is it worth?

    I take all the money my kids’ grand- and great-grand-parents give our kids and put it into a Coverdell ESA. I am not sure if I’m doing that right (does it mean my kids are gifting me the money and I am gifting it right back to them in the ESA?). But at least some day they can know that e.g. their books for the first year of college were paid for by their dearly departed great grandparents.

    • Lazy Man says:

      We’re starting with $1000-1500, so it might not grow beyond $6000 (just roughly applying a “rule of 72” twice) without more money being added.

      If I didn’t put in the kids name, then LTCG would help, right? For all practical purposes it wouldn’t be recognized as an account for a minor right? This is the kind of thing that I hope my tax advisor can help with. For the most part, I just want to avoid this money getting taxed at our marginal rate.

      I like the idea of Coverdell’s, because I think it can include things like computers, not just books and tuition. I think we’ll open up a Coverdell at some point for these “incidentals” that will certainly add up. That’s a different, head-exploding discussion.

  4. Evan says:

    I think your fears as well as your expectations are misplaced.

    1) You are buying and holding an ETF – what taxes are you going to incur? Dividends? Of what – a couple of bucks? If it is yielding 2% and you have $2,000 in it you are talking about $40 of income or even at 40% marginal rates (obviously being silly) a whopping $16 of extra taxes. It isn’t like you are buying a mutual fund where you are going to incur forced, phantom capital gains income.

    2) You are alright with being forced to give money to a 21 year old? I am not sure if you remember yourself at 21, but this guy right here, was an idiot…nay a fucking moron. 34 year old Evan would be pissed at my father if he gave me a check like that.

    • Lazy Man says:

      1. I’m not concerned about ongoing taxes of dividends. I’m more concerned about the sale of the ETF when the (assumed) gains are realized. I don’t want those gains to be at marginal rates. Perhaps I’m answering my own question because I think it would be LTCG. However, it seems that would be the normal case for a UTMA (who actively trades in such accounts?), so why emphasize the marginal rates?

      In short, I don’t care too much about being taxed 10-15%, but I care more about being taxed in the 30% area.

      2. 34 year old Evan sure is surly ;-). The idea isn’t to give a big check to them at age 21. It is more like, “Let’s use this money to buy a car, which I know you want.” How much is $1000-1500 going to grow in 14-15 years when they are looking to make that purchase anyway?

      Would it be fair to argue that you might ahead of your father in teaching personal finance to your kids… hence they may not be the same kind of moron with money at 21?

      For what it’s worth, 20-year old Lazy Man was investing in Legg Mason Value Trust, fairly early in the Bill Miller run of beating the S&P 500. (Yes it was mostly luck and I probably paid a big load.)

  5. Evan says:

    The tax point since that seems to be the hold up for you (when I really believe it is point 2 that is MUCH more important given the amounts discussed). All you have to do is gift your child the account in kind, they get your basis, and then sell at their tax rate. So if they are like most college kids they might be in the lower tax bracket for long term capital gains taxes. This all assumes nothing changes in the tax laws in the 20 or so years we have to go.

    Notwithstanding the tax issue, the reason I get so passionate about it is I really believe most 21 year olds do not make good long term decisions. Think you could name 4 other 21 year olds who knew what the Legg Mason Value Trust was? Hell, do you think you could name 12 other adults, who do not own a PF Blog, that can adequately describe a mutual fund. While you may have made great decisions at 21 – what if your child either doesn’t make good decisions or worse has a substance abuse problem. That money is theirs. Period. Not, “Hey dad lets go buy a car” theirs, but actually theirs as in “I don’t care what you say, I am 21 and am going to the bank to cash everything out to be booze or drugs.”

    For that kind of protection I am happy to pay some (extra) taxes. If the money had an extra zero (either in my case or your case) I would wrap it up in a trust.

    • Lazy Man says:

      Good point about the taxes. That kind of pushes me towards putting it in my own name… but… it greatly ignores your second point of how a 21 manages the money.

      I’m not arguing that the average 21 year old isn’t going to be fiscally responsible. I’m sure they are terrible like almost every other 21 year old I knew. That said, some of my best friends when I was 21 were reading Buffett for fun and managing their money with Quicken. It could have been coincidence.

      I’m banking on them saying, “I want a car” at age 16. How many 16 year olds don’t want a car?

      As you say, “that money is theirs.” It is supposed to be theirs as the givers intended it to be that way.

      It sounds like in either scenario it is better to keep the money in an account in my name. It seems to protect against either scenario, right?

  6. Evan says:

    As you say, “that money is theirs.” It is supposed to be theirs as the givers intended it to be that way.
    – If I were to give your kid money, even if it were a decade it was meant to buy something worthwhile and I would be glad he or she has a great dad that can influence the decision. Example – Maybe I, as the donor, would love for it to be used for transportation, but maybe I wouldn’t be as thrilled if it was used to buy a crotch rocket that goes 0 to 60 is 3 seconds without the protection of airbags.

    “It sounds like in either scenario it is better to keep the money in an account in my name. It seems to protect against either scenario, right?”
    – All I was saying! All the good and none of the bad.

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  9. Big-D says:

    I can tell you that I am an example of a second generation person using UGMA/UTMA accounts for child’s college funds. I had one from my parents, and my son (who is 21 and a Senior in school) has one. Here are some thoughts on this thread (I know – sniping several months after the post, but I have finally gotten time to read your past posts).

    1) I think this gives you the most flexibility for spending for college savings. Yes it is not the most tax advantaged, but gives you way more flexibility. As the account is in your child’s name, and you are the custodian, you manage it until they turn age of majority, and they choose to take you off the account. In Indiana, that is 21. I managed my son’s account until he was 21. My parents managed mine until I was 19 (different reasons, legal protections from a child support as it was my college fund).

    2) Due to the way that the accounts are setup, you can enforce the fear of god in them (and legal control until they are 21) that they cannot spend anything. You can direct where the money goes, and should be for college and not a corvette at 16. Technically since they cannot touch the money until they are 18, they cannot do anything you mentioned as you are managing the accounts until they hit that age.

    3) Taxes. Kiddie taxes are applicable if a child makes enough money above the threshold and you wish to apply those taxes, at your tax rate, on your return. If my son made dividends above and beyond the thresholds, I just filed taxes for him w/ the state/federal government. It was a simple matter when you use turbo tax or anything to get done. He never had to pay more than a few dozen dollars on his account which was up to $60k when he started school, so I just paid it out of my account.

    4) When you begin to sell shares, to cover expenses, they will have to fill out tax forms. Again, no big deal and you don’t need to declare kiddie taxes (as they are adults). It is really easy if they had a part time job and got a W-2.

    5) I am in my early 40’s now, and I still have the money I didn’t spend from my UGMA/UTMA account. The mutual fund my father bought in 1990, for $10k, which I have never sold, is woth over $125k now (depending on the market). I just have let it stay as it does well and my basis on that sucker is like $25k (tons of dividends). There were other investments and I used it pay for my first down payment on my first house when I graduated with my first masters degree.

    I think it can be a wonderful thing if you manage it, manage what your kids do, set expectations, and treat it like it is, a long term gift you are giving your kids, which they will be able to use for school and life. It is a wonderful launching pad for them.

    • Lazy Man says:

      How is the financial treatment of them? If they are in the child’s name, wouldn’t that count as a big hit on the FAFSA?

      I’d love to have the fear of God, but it is honestly their money and I want to do everything to maximize financial aid down the line.

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