Best Ways for Kids to Invest Gift Money

Years ago, parents used passbook savings accounts to teach their children about the magic of compound interest. Unless your goal is to teach your son what happens when the Fed lowers interest rates to zero, you’ll want to find other ways to invest the money.

First, though, you’ll need to set up a custodial account under the Uniform Transfers to Minors Act (UTMA) or the Uniform Gifts to Minors Act (UGMA). Brokerage firms and mutual fund companies can provide you with the forms you need. An adult must be appointed custodian, a role that you or your spouse can assume. Once your child reaches the age of majority, usually 18 or 21, he will get full control of the account. If he decides to cash it out and buy a Harley, there’s nothing you can do about it.

You can invest an UTMA/UGMA in just about anything—stocks, mutual funds, exchange-traded funds—as long as you meet the financial institution’s investment minimum. Consider a total stock market index fund, which invests in virtually all publicly traded U.S. companies, suggests Rose Swanger, a certified financial planner in Knoxville, Tenn. TD Ameritrade offers custodial accounts with no investment minimum and hundreds of no-transaction-fee funds. Online stock trades cost just $9.99. Charles Schwab’s custodial account has an investment minimum of $100, and Schwab charges $8.95 to buy and sell stocks online. It also offers a large slate of no-transaction-fee funds.

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Watch out for taxes. If your child proves to be an adept investor (or receives a lot more gift money), you could end up paying the “kiddie tax.” Under kiddie-tax rules, the first $1,050 of interest, dividends and capital gains from the account is tax-free; the next $1,050 is taxed at the child’s rate. Earnings above $2,100 are taxed at the parents’ rate. Consider this an opportunity to teach your child about the impact of taxes on investment returns—and the importance of tax-efficient investing. You can minimize the kiddie tax, for example, by avoiding short-term gains, which are taxed at your ordinary income rate. Hold investments for more than a year and you’ll pay long-term capital gains rates—typically 0% to 15%.

Impact on financial aid. When it is time to apply for college, an UTMA/UGMA account will reduce your child’s eligibility for financial aid. The federal financial aid formula counts 20% of a child’s assets (and that includes custodial accounts) when considering how much a family can afford to contribute toward college costs, versus a maximum of 5.64% of parents’ assets.

To avoid that problem, you could invest the money in a custodial 529 college-savings plan. Custodial 529 plans are considered a parental asset under the financial aid formula. If you already have an UTMA/ UGMA, you can convert it to a custodial 529 plan. Because 529 plans accept only cash, you’ll have to sell the investments in the account first. If you have a lot of investment gains, you can lower the tax hit by stretching the conversion over several years, says Joe Hurley, founder of SavingforCollege.com. Once the money is in the 529 plan, gains are tax-free, as long as the money is used for qualified educational expenses.

One possible sticking point: Parents can change beneficiaries in their own 529 plans, but a custodial 529 plan must remain in your child’s name. When your child reaches the age of majority, he will gain control of the account.