The best mutual funds for kids are not unlike the best types of funds for any other beginning investor. There are a few basic steps to get kids started with investing: set some basic goals, open a minor account, and choose the right type of fund to meet the investment objective.
In this article, we'll cover the best types of accounts and mutual funds to get kids started with investing, and to help them learn along the way.
What Are the Best Investment Account Types for Kids?
Some types of investment accounts are created specifically with children in mind, whether to fund college, pass on a legacy gift, or secure the child's future.
Assuming the child is under the age of 18, they'll generally need a minor account to get started investing. In some cases, minors can open an their own retirement accounts. Adults, such as a parent, can also open investment accounts on behalf of their minor children. Typically, these accounts are to save for school or other long-term goals.
By law, minor children cannot open savings (or checking) accounts. By acting as a custodian, you can set up an account that is the child's property yet remains under your management until they turn 18. Another option would be to set up a joint account that is shared by both of you.
Here are the main types of accounts minors can use for investing:
- UGMA/UTMA: Accounts created under the Uniform Gift to Minors Act (UGMA) or the Uniform Transfer to Minors Act (UTMA) can be used for investing in securities, such as stocks, bonds, or mutual funds, on behalf of a minor. Whether you open an UGMA or an UTMA depends on which state you live in.
- Roth IRA: Children may qualify to open an Individual Retirement Account (IRA) if they have earned income. For example, if they do yard work for the neighbors or have a small summer job and claim this income on a tax return, they could start their own IRA and begin saving for retirement.
- Education Savings Account (ESA): Also called a "Coverdell Education Savings Account," this account is a trust used to save for college. It can also be used for many types of expenses associated with college, such as books, supplies, and sometimes even room and board. Withdrawals are tax-free, so long as the funds are used for these qualified expenses. An ESA accounts is opened by an adult, who serves as custodian, on behalf of the child. The trustee can contribute up to $2,000 each year and no more.
- Section 529 Plan: Also known as a "qualified tuition plan" (QTPs), the 529 plan is similar to the ESA in that it is designed to pre-pay for a child's future education. Unlike the ESA, the 529 plan is not a trust that passes to the child, but rather remains in the name of the adult who opened it. 529 plans are sponsored by states and authorized by Section 529 of the federal tax code. These plans offer tax perks and investing options that vary by state.
Accounts designed for children typically come with strict rules from the state so that adults can't take advantage. Steep tax penalties are one way to enforce contribution limits and account spending.
Investing for Kids Can Start With Just One Mutual Fund
If you want to take the most simple route and invest with just one fund, there are a few options that work best in terms of keeping costs and risks low:
- Index Funds: Funds that track a broad market index, such as S&P 500 index funds, can be a great place to start out with mutual funds. This is because most of these funds have low expense ratios, meaning they cost very little to manage, and they are spread across dozens or even hundreds of stocks; a single fund can consist of stock from companies across a wide range of different industries. Vanguard, Fidelity, T. Rowe Price, and Charles Schwab are some of the best-known investment firms for index funds.
- Balanced Funds: Also called "hybrid funds" or "asset allocation funds," these invest in a balanced array of stocks, bonds, and cash. The allocation usually remains fixed, and the professionals who manage the funds stick to a stated objective or style. This balance of stocks and bonds provides good diversity in just one fund.
- Target Date Mutual Funds: Also called "life-cycle funds" or "target retirement funds," target date mutual funds invest in a mix of stocks, bonds, and cash to best suit the needs of someone who plans to cash out in a certain year or decade. As the target date approaches, the fund manager will decrease market risk by shifting assets out of stocks and into bonds and cash; this move is what a prudent investor would do if working on his or her own.
How Kids Can Get Started Investing With $50 or Less
One drawback of some mutual funds is that they can require money upfront to fund your account. The minimum can be up to a hefty $1,000 or more to get started, but there are cheaper options.
Here are some diversified mutual funds with a minimum investment of $50 or less:
- Schwab Balanced Fund (SWOBX): This fund invests in a mix of stocks and bonds. There is no minimum initial investment required.
- Fidelity 500 Index Fund (FXAIX): This fund follows the S&P 500 index by investing in approximately 500 of the largest U.S. companies. There is no minimum initial investment required.
- USAA Target Retirement 2060 (URSIX): Target retirement funds can be set up for people who know approximately when they expect to retire. This fund is set up for people who expect to retire in about 45 years; it starts off as mostly stocks, then gradually shifts toward bonds as the target year approaches. When paired with a structured plan, the minimum initial investment is only $50.
The old adage "Time is money" is one of the best reasons for kids to start a mutual fund account. With the advantage of compounding, even modest investments stand to grow over time, and at ever-increasing rates. Kids have the advantage of many years to watch their account balances curve upward.
The Bottom Line
There are multiple account options and types of mutual funds that can be used to get kids started in investing. From education savings accounts sponsored by an adult, to IRAs in the child's name, kids can take advantage of compounding returns and build wealth over time. Be sure to choose the account types and mutual funds most appropriate for your child's goals.
Frequently Asked Questions (FAQs)
How do you set up a custodial account for a child?
Opening a custodial account for a child is similar to any other account-opening process. All you really need is basic information about yourself and the child. If the custodial account is an investment account for mutual funds, then you'll also need to link one of your existing bank accounts to add investing funds.
Who pays taxes on mutual fund profits held in a child's custodial account?
The funds held in a custodial account are the minor's property. That means the child would owe taxes on any capital gains or distributions from mutual funds held in the custodial account, but there are some unique tax rules that apply to custodial accounts. The first $1,050 in unearned income from these accounts is tax-free. The next $1,050 is taxed at a reduced child's tax rate. After the first $2,100, the income is taxed according to the parent or guardian's federal tax bracket rate.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.