Children who take advantage of investing by letting their money remain invested for several years can all but guarantee healthy financial returns for themselves in the future. It can also teach them the vital skills and financial literacy that will help them make savvy investment decisions as an adult.
If you want to teach your kids valuable lessons about money and the power of compounded growth, helping them open an investment account can be a great start. To get your kids started with investing, you should first decide which investment account is best for them. That decision largely hinges on whether they have earned income and they type of expenses you wish to cover:
Investing for your child’s education
- A Coverdell ESA account allows parents to invest a maximum of $2,000 per child per year for a range of primary, secondary and post-secondary school expenses. These include tuition, books, uniforms, transportation and room and board.
- You can open an ESA for your child if you and your spouse earn less than $220,000 per year collectively — or if you are single and earn less than $110,000. (You will not be able to contribute the full $2,000 if you earn more than $190,000 collectively or $95,000 if single. Anything you do contribute above the limit may be subject to a 6% penalty tax.)
- Although Coverdell ESAs have low contribution limits, they do offer a lot of investing freedom. Funds can be invested in stocks, sukuks, real estate etc.
- Earnings and withdrawals are tax-free if used for qualified expenses for taxpayers who don’t claim an American Opportunity credit or Lifetime Learning credit for the same expenses in the same year.
- The account should also be emptied before your child’s 30th birthday to avoid being charged income tax and a 10% penalty tax on the remaining funds. However, parents have the option to change the beneficiary on the account to an eligible family member under the age of 30 to circumvent this situation.
If your child has taxable income or wages
- If your children have earned income (money earned from a W-2 job, or from self-employment like baby-sitting or lawn mowing), you can help them open a custodial IRA. Children of any age can contribute to a custodial IRA as long as they have earned income.
- Custodial IRAs come in two flavors: traditional and Roth IRA.
- With a traditional IRA, you pay taxes when you withdraw the money during retirement (at your then-applicable tax rate).
- With a Roth IRA, you pay taxes when you put the money into the account, so the funds—the contributions and their earnings—are considered after-tax money.
- Because many children do not earn enough money to benefit from the up-front tax deduction associated with traditional IRAs, it makes sense in most cases to focus on Roth IRAs where the contributions your child makes to the account will grow tax-free. A Roth IRA is also more flexible than other retirement accounts because contributions can be withdrawn at any time. The investment growth can be tapped for retirement, but also for a first-home purchase and education.
- A parent or other adult will need to open the custodial IRA for the child and serve as a custodian until the child turns 18. When they become a legal adult, the account can switch hands.
If your child doesn’t have taxable income or wages
- Under the Uniform Gift to Minors Act or Uniform Transfer to Minors Act, parents can open custodial brokerage accounts for their kids to save for college, a wedding, or a first home.
- Although the account will initially be in the parents’ name, the child will be able to take full control of it once he or she reaches age 18 or 21, depending on state laws. However, some states allow custodians to maintain control until the child turns 25.
- UTMA/UGMAs have unique advantages because there are no restrictions on the use of funds. For example, Coverdell ESA requires your child to use the funds on tuition or other educational expenses. The assets in UGMA/UTMA can be applied towards tuition but could also pay for a wedding or set up a business, as long as the expenditure is for the benefit of the child.
- UTMAs are also a good strategy for passing wealth from one generation to the next. Parents can contribute up to the gifting limits of $15,000 ($30,000 for couples) annually gift tax-free.
Regardless of the path you take to help your child start investing, the key is to get them started early. You may not be investing for your children forever, but you can help them develop important financial habits and skills they’ll use their entire lives. If you are not sure about how to get started, feel free to talk with one of our financial advisors today to choose investments that satisfy your child’s best interests. As always, your financial advisor can provide guidance and insights to determine which account type and benefits might be optimal for you and your family.
Rezwana Abed is an Investment Advisor Representative at ShariaPortfolio. She is based in San Francisco Bay Area and serves ShariaPortfolio’s clients in California and beyond. Rezwana holds a Masters degree in Public Policy from UC Berkeley. rezwana@shariaportfolio.com
Investing in securities involves risk, and there is always the potential of losing money when you invest in securities. Halal compliant investments, diversification and asset allocation do not ensure a profit or protect against loss. This material is intended for informational purposes only and should not be construed as legal or tax advice, nor is it intended to replace the advice of a qualified attorney or tax advisor.