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Opening a brokerage account can be a great way to teach your kids about the stock market. They might also get the opportunity to watch their money grow over the long term. While a minor cannot open a brokerage account on their own, there are ways for parents and guardians to establish them for youngsters.
How to Set Up a Brokerage Account for Your Child
A brokerage account is a taxable account that lets you buy and sell securities such as stocks, bonds, mutual funds, exchange-traded funds (ETFs) and more. You may owe capital gains taxes on money you make on your investments, but there are no contribution limits or penalties for withdrawing your money.
Where kids are concerned, parents and guardians can open something called a custodial brokerage account. This is an investment account that's in a child's name but is managed by an adult until the minor comes of age. Together, you can select investments, make trading decisions and, if all goes well, watch your money grow. If not, market volatility can be a teachable moment in itself. No matter the outcome of your investments, a custodial account can be an effective way to begin cultivating healthy financial habits with your child.
These types of custodial accounts can be opened through most financial institutions and brokerages. When comparing your options, be on the lookout for fees, minimum opening deposits and other restrictions. The idea is to find a low-cost way to teach your child about the ins and outs of investing. Just bear in mind that due to gift tax laws, contributions to a custodial brokerage account might have a limit of $16,000 per year.
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Different Types of Custodial Accounts
There are a few different kinds of custodial accounts. The right one for your child will depend on their unique financial situation:
- Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) account: One of the ways these types of custodial accounts can be used by adults is to invest on a minor's behalf. The account is managed by an adult, but the child technically owns the assets. Contributions are usually irrevocable, which means the adult can't take them back. The exact rules around these types of accounts vary from state to state, but the child can typically take control of their account when they turn 18 or 21.
- Custodial individual retirement account (IRA): Adults can open a traditional IRA or Roth IRA on their child's behalf. Each account type has its own unique tax benefits, and either are ideal for minors who have earned income. Roth IRAs allow earnings to grow tax-free, and there are no withdrawal penalties. No matter what type of custodial IRA you choose, contributions cannot exceed the minor's earnings. They also cap at $6,000 for 2022.
- 529 savings plan: This tax-friendly account is designed to make saving for college a little easier. The money in a 529 plan can be used to cover K-12 tuition, college tuition and other education costs. It also grows tax-free if withdrawals are used for qualified education expenses. An adult can open this type of account in their own name, then make contributions and manage the account while listing the minor as a beneficiary. This provides some flexibility because if that child chooses not to attend college, the adult can transfer the funds to another beneficiary or withdraw it and pay a penalty.
- Coverdell Education Savings Account (ESA): A Coverdell ESA is another college savings vehicle. It works like a 529, but doesn't allow you to contribute quite as much annually. There are also income limits, which may make them less appealing to high earners. However, they're generally considered less strict in terms of what counts as a qualifying educational expense.
- Youth accounts with financial institutions: Many banks and financial institutions offer bank accounts designed for minors. While it isn't technically a custodial account, the Fidelity Youth Account, for example, allows parents and guardians to monitor their teen's account activity and trade confirmations. Account assets belong to the minor, and the account automatically transitions to a retail brokerage account when they turn 18.
Who Pays Taxes on a Custodial Account?
Money generated from investment gains or dividends is considered unearned income. Dependent children need to file a federal tax return if their unearned income exceeds $1,150. The next $1,150 is taxed at the child's own income tax rate, which will likely be much lower than their parents'. Anything that exceeds $2,300 will be taxed at their parents' income tax rate.
Earned income from an employer is a little different. Dependent minors are required to file federal tax returns if their earned income exceeds $12,950 in 2022.
What Happens to a Custodial Account When Your Child Turns 18?
The age at which the child can take over assets in their custodial accounts varies by state. It's typically 18 or 21, but it could be older. In California, for example, the custodian can hang on to the account until the minor turns 25 in some cases. When the minor reaches this "age of majority," they can claim full control of their custodial accounts. If the custodian fails to initiate the process of transferring ownership, the account could be restricted until they do so.
The Bottom Line
Close to 63% of parents say they've talked to their kids about at least one major financial concept, according to a 2019 Policygenius survey. Topics like debt, budgeting, taxes and charity were among the most discussed. That's certainly encouraging, but it points to one important topic that appears to be falling through the cracks—investing.
The best way to teach your kids about financial wellness is to lead by example. Setting up a brokerage account for your child and involving them in the process of managing it can prepare them for a successful future managing their money.
You can also take the opportunity to teach them about credit. Experian makes it easy to check your free credit report and credit score whenever you need it. It's a key part of maintaining your financial health—which is another valuable lesson to pass on to your children.