Tax advantaged accounts for young children?

[Mississippi Mudstache]

We have two kids, ages 1 and 3. We save all of their birthday/Christmas money in savings accounts at CapitalOne360. Currently it adds up to about $750 between the two of them. Now that the amount is creeping up near $1000, I feel like it's time to starting investing the money for them instead of watching it lose value to inflation each year.

I know that I can't legally put the money into an IRA, since it would be impossible to prove that my toddlers have earned income. Are there any other options available? I really just don't want to deal with the hassle of complicating my taxes with taxable accounts if I don't have to. Currently, all of my investments are held in IRAs, 401ks, and HSAs, which makes things really simple each spring.

I guess it's not really a big deal if I do have to go with a taxable account, I just thought I might throw this one out to the brain trust to see what others might be doing.

[beltim]

If you open up taxable accounts in their names, they're unlikely to have any tax reporting or liabilities until their account gets much bigger.  Specifically, you open a custodial account (UGMA or UTMA, depending on the state) and the first $1000 of unearned income is tax-free:
https://www.franklintempleton.com/retail/pages/generic_content/prog_serv/ugma_utma/ugma_utma_pub.jsf#.VN5H3cY_Zt0

[Mississippi Mudstache]

If you open up taxable accounts in their names, they're unlikely to have any tax reporting or liabilities until their account gets much bigger.  Specifically, you open a custodial account (UGMA or UTMA, depending on the state) and the first $1000 of unearned income is tax-free:
https://www.franklintempleton.com/retail/pages/generic_content/prog_serv/ugma_utma/ugma_utma_pub.jsf#.VN5H3cY_Zt0

Awesome. That's exactly what I was looking for.

[ncornilsen]

Remember that at age 18, your child can take money from a UGMA and immediately spend it on a fancy car and drugs... There are no strings you can put on it. something to keep in mind.

[Mississippi Mudstache]

Yeah, not really worried about that.

[madamwitty]

Be aware that custodial accounts can negatively affect financial aid eligibility when it comes time for college. When the stash gets big enough to start owing taxes, or when it's almost time for college, you might consider putting some of the money into a 529 plan account. It must be used for higher education purposes (or else there's a penalty), but the earnings in the account aren't taxable and the account is assessed more favorably for financial aid purposes.

[Mississippi Mudstache]

Be aware that custodial accounts can negatively affect financial aid eligibility when it comes time for college. When the stash gets big enough to start owing taxes, or when it's almost time for college, you might consider putting some of the money into a 529 plan account. It must be used for higher education purposes (or else there's a penalty), but the earnings in the account aren't taxable and the account is assessed more favorably for financial aid purposes.

Thanks, that's definitely a reason for concern. Since the amount I'm putting away for them currently only amounts to $150-200/year (basically, it's just whatever family gives them for birthdays and Christmas), I don't expect the amount of money in the accounts to get too out of control. However, in the future, if the kids start earning some income, I may look into the possibility of rolling the accounts into an IRA prior to college to help with financial aid eligibility. I think that, for now, the custodial account seems like the way to go. I've already opened up a couple at Fidelity, actually.

[madamwitty]

However, in the future, if the kids start earning some income, I may look into the possibility of rolling the accounts into an IRA prior to college to help with financial aid eligibility. I think that, for now, the custodial account seems like the way to go. I've already opened up a couple at Fidelity, actually.

An IRA is a great way to go when they start earning!

[GizmoTX]

Don't overlook the Kiddie Tax on custodial accounts, which has been extended until age 24. 

http://www.schwab.com/public/schwab/nn/articles/Saving-for-College-Custodial-Accounts

http://www.savingforcollege.com/articles/ugma-utma-conversions-to-529

[Mississippi Mudstache]

Yeah, beltim mentioned in the second reply. I doubt that the earnings will ever approach the annual threshhold, but if it does, that would be awesome.

[mxt0133]

My plan is to gift my kids enough appreciated stock so they can realize up to $2100 in unearned income every year.  As it grows they can sell, realize the gains and get a step up in basis.  They can then gift it back to me or use it for family expenses when the time comes so that it is depleted before college.

[Gin1984]

My plan is to gift my kids enough appreciated stock so they can realize up to $2100 in unearned income every year.  As it grows they can sell, realize the gains and get a step up in basis.  They can then gift it back to me or use it for family expenses when the time comes so that it is depleted before college.

There are rules on what the "child" or the custodian can spend the money from a custodial account.  For example, you can't use it for expenses that you, as the parent, are required to supply, like food clothing, shelter or daycare (if you need it to work) but you can use it for college applications, preschool and "fun".

[mxt0133]

My plan is to gift my kids enough appreciated stock so they can realize up to $2100 in unearned income every year.  As it grows they can sell, realize the gains and get a step up in basis.  They can then gift it back to me or use it for family expenses when the time comes so that it is depleted before college.

There are rules on what the "child" or the custodian can spend the money from a custodial account.  For example, you can't use it for expenses that you, as the parent, are required to supply, like food clothing, shelter or daycare (if you need it to work) but you can use it for college applications, preschool and "fun".

Fun it is then!  I'm sure they can gift it as well.

[Gin1984]

My plan is to gift my kids enough appreciated stock so they can realize up to $2100 in unearned income every year.  As it grows they can sell, realize the gains and get a step up in basis.  They can then gift it back to me or use it for family expenses when the time comes so that it is depleted before college.

There are rules on what the "child" or the custodian can spend the money from a custodial account.  For example, you can't use it for expenses that you, as the parent, are required to supply, like food clothing, shelter or daycare (if you need it to work) but you can use it for college applications, preschool and "fun".

Fun it is then!  I'm sure they can gift it as well.

I am under the impression they can't because the money must be spent to the "benefit" of the child. 

[mxt0133]

I am under the impression they can't because the money must be spent to the "benefit" of the child.

I meant after they turn 18.  I figure if I did my job correctly then they would have no issues giving it back, if I didn't then I failed and don't deserve the money.  It's motivation to be nice to them, haha.

[Gin1984]

I am under the impression they can't because the money must be spent to the "benefit" of the child.

I meant after they turn 18.  I figure if I did my job correctly then they would have no issues giving it back, if I didn't then I failed and don't deserve the money.  It's motivation to be nice to them, haha.

I have to check, but it may be until 24 or 22 as long as you still claim them as a dependent. 

[GizmoTX]

Generally a full-time student must be claimed as the parents' dependent until 24, unless married or ex-military.

[Gin1984]

Generally a full-time student must be claimed as the parents' dependent until 24, unless married or ex-military.

A full time undergrad (who has not completed a previous BA/BS) student, not just a student.

[seattlecyclone]

Generally a full-time student must be claimed as the parents' dependent until 24, unless married or ex-military.

A full time undergrad (who has not completed a previous BA/BS) student, not just a student.

For financial aid purposes, sure. The parent has to report their income on their undergraduate child's FAFSA unless certain exceptions (marriage, military, etc.) apply.

For taxes, no such requirement exists. A full-time student under 24 meets the age test for dependency, but they still need to meet the rest of the tests. The support test is key here. If the student is paying more than half of their expenses out of their own work and savings (including any previously-gifted UTMA funds that became theirs at age 18), they can't be claimed as anyone's dependent.

[tonysemail]

I've been reading about UGMA vs 529 plans recently.
I thought I would share one of the useful articles on this forum.
as usual, the topic has been well covered, so I'm appending this comment to a prior thread.

this article from 2008 explains the tactic.
http://www.savingforcollege.com/articles/should-you-open-an-ugmautma-529?page=1

to summarize, the steps are:
1. gift appreciated stock to minor's UGMA brokerage account
2. harvest up to 2k of capital gains at child's tax rate (amounts above 2k are subject to kiddie tax)
3. transfer the proceeds to UGMA 529 plan for tax free growth and other benefits
4. file tax return for kids (ouch!)
5. rinse and repeat next year

the benefit to the parent is sheltering 2k/year of capital gains.
the benefit to FAFSA is that 529's only count 5.64% towards EFC, even when held in student's name.
Additionally, it separates 529 accounts for each child, such that elder sibling's FASFA will not be penalized for 529 assets held for younger siblings.

So all in all, it's more work than a regular 529, for some incremental gain.
I'm leaning towards doing it this year, although I'm still in the "researching" phase and I haven't actually opened any accounts yet.

[Undecided]

Remember that at age 18, your child can take money from a UGMA and immediately spend it on a fancy car and drugs... There are no strings you can put on it. something to keep in mind.

In my state it's 25; might be worth looking at the applicable state law.

[KisKis]

Way late on this thread, but I also have young children (4 & 7) and I actually copied Mr. Money Mustache's "Bank of Dad" method.  http://www.mrmoneymustache.com/2015/05/20/what-im-teaching-my-son-about-money/

It's been almost a year, and it's going really well.  I give the kids 10% annual interest, compounded monthly, and while they aren't super interested, they are always very excited to "deposit" money into the "Bank of Mom," and they seem momentarily impressed by seeing monthly interest being added.  They do get a bit competitive with their total savings, but they can also be generous to each other.  I always ask them if they are absolutely sure they want to spend the money, but, for example, one time my daughter paid my son $2 to finish her vegetables.  Another time, I was giving cash as a birthday gift to one of her classmates, but my daughter was adamant about supplementing it with $10 from her own fund.  (Kids are weird.)

I deposit the actual money into my own accounts and invest accordingly.  The kids are always free to make "withdrawals," and I just give them the cash or pay for the item, but then we remember to subtract the amount from their spreadsheet when we get home. 

Since your kids are so young, this might be a fun learning tool and it will also solve the previously mentioned tax considerations.