Rules and Regulations for Investing With Kids

There are several good reasons to learn the rules and regulations for investing with kids. Investing for your children is good for them -- and not just for their pocketbooks. Watching their investments grow will teach your children practical lessons in the value of patience and persistence and will supply incentives to prepare for the future.

However, it is essential to invest properly, scrupulously following the tax laws while still taking full advantage of arrangements that shelter your children's assets. Minors cannot legally make contracts, but there are ways that money can be invested for them.

UGMA and UTMA

The Uniform Gifts to Minors Act and the Uniform Transfers to Minors Act govern custodianship. Accounts ruled by these acts can be used for funds to provide extras for a child but cannot be used for his or her support or maintenance. To do so would break the law, void tax savings and probably incur penalties. For example, a child might be provided with a computer but not food or clothing with funds from his or her account.

The Uniform Gifts to Minors Act controls gifts you give your child. You retain control until the child comes of age at 18 or 21, depending on jurisdiction. You can control stocks, money, life insurance, annuities and similar investments in such an account.

Using the Uniform Transfers to Minors Act, you may retain control until the child is somewhat older, perhaps as old as 25 in some jurisdictions. With this arrangement, you can give real estate, royalties and fine art as well as financial assets.

Traditional and Roth IRAs

Traditional IRAs reduce taxes. There are serious penalties for withdrawing from them before age 59, however, unless they are used to pay post-secondary educational expenses or for certain other limited purposes, such as part of a down payment on a first home. You control this account for your minor child. However, there is a catch. A child's IRA can only shelter income that the child earns by himself or herself. You cannot give your child money for an IRA. In addition, control passes to your child at the age of majority, which may be age 18 where you live.

Roth IRAs are very similar, except that the money is not deducted from income for the child's tax purposes (usually not a problem), and there are no penalties for withdrawing contributions at any time.

529 plans

These college savings plans are available in most states and enable parents to save for college in a tax-efficient way. Individual state plans vary, but in general parents will be better off with direct-sold plans purchased from the plan sponsors, which avoid broker "loads" (costs). There may also be additional tax advantages in using the particular plan sponsored by your own state rather than that of another.

Funds must be used for eligible college expenses, or penalties and taxes will be assessed. Generally, participants are restricted in their investment choices and allowed to change their investments relatively infrequently.

Coverdell ESA

The Coverdell Educational Saving Account is similar to an IRA. Money from the plan can be withdrawn at any time for education, and if the child does not use it by age 30, another family member can. The money from a Coverdell can be used for educational expenses at the elementary or secondary level. "Virtually all accredited public, nonprofit and proprietary (privately owned profit-making) post-secondary institutions are eligible," according to the IRS.

The contribution limit is lower than that of the 529 plan, but the money can be invested in a broader variety of investments with more freedom to move the money around within the plan.

Choosing the correct plan and following its rules and regulations is important. Even more important, though, is contributing consistently while using the plan to educate your child about the importance of saving, setting goals and planning for the future.

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