What Is the Best Investment for a Grandchild?

Many individuals aim to contribute to their grandchildren’s financial well-being, whether for future educational pursuits, a significant life event such as a home down payment, or general financial security. Various investment vehicles are available to help achieve these goals, each with distinct features and benefits. Understanding these options is crucial for making informed decisions.

Education Savings Plans

Education savings plans, commonly known as 529 plans, are investment vehicles designed to help families save for future education expenses. These plans offer significant tax advantages, as earnings grow tax-free and withdrawals are also tax-free when used for qualified education expenses. Qualified expenses include tuition, mandatory fees, books, supplies, and equipment for enrollment or attendance at an eligible educational institution. Room and board expenses also qualify if the student is enrolled at least half-time.

Beyond traditional college costs, 529 plans can cover up to $10,000 annually per beneficiary for K-12 tuition. Beginning July 4, 2025, additional K-12 expenses like curricular materials, books, tutoring, and testing fees will also be considered qualified expenses, though the $10,000 annual limit remains. Funds can also be used for registered apprenticeship programs, covering fees, books, supplies, and equipment. Up to $10,000 in principal or interest on qualified education loans per beneficiary can also be paid from a 529 plan.

The ownership structure of a 529 plan impacts financial aid eligibility. If a parent or dependent student owns the account, it is reported as a parent asset on the Free Application for Federal Student Aid (FAFSA), reducing aid eligibility. However, for the 2024-2025 academic year and beyond, 529 plans owned by grandparents or other relatives are not reported on the FAFSA, and distributions from these accounts are not treated as student income. The account owner maintains control over the funds, and beneficiaries can be changed to another qualified family member.

Custodial Accounts

Custodial accounts, established under the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA), hold and manage assets for a minor until they reach a specified age of majority. Unlike 529 plans, UGMA/UTMA funds are not restricted to educational expenses and can be used for purposes like a car or a home down payment. The designated custodian manages the account, including investment decisions, until the child reaches legal adulthood.

The assets legally belong to the minor, and the custodian must transfer control to the beneficiary upon reaching the age of majority. This age typically ranges from 18 to 21 years, depending on state law. Once the minor reaches this age, they gain complete access and discretion over how the funds are used.

Regarding taxation, unearned income generated within UGMA/UTMA accounts may be subject to the “kiddie tax” rules. For the 2025 tax year, the first $1,350 of a child’s unearned income is tax-free. The next $1,350 is taxed at the child’s own tax rate. Any unearned income exceeding $2,700 for the 2025 tax year is taxed at the parent’s marginal income tax rate. These tax rules apply to children under 18, and in some cases, to full-time students between ages 19 and 23 with unearned income above the threshold.

Retirement Savings for Grandchildren

While less conventional for young grandchildren, a Roth IRA can serve as a long-term savings vehicle, particularly for retirement. A requirement for contributing to a Roth IRA is that the grandchild must have earned income. This includes wages from a job or net earnings from self-employment activities like babysitting, dog walking, or mowing lawns. Even very young children engaged in activities like modeling can qualify if they earn income.

The amount that can be contributed to a Roth IRA for a minor is limited to the lesser of their annual earned income or the IRS contribution limit, which is $7,000 for 2025. Contributions are made with after-tax dollars, meaning they are not tax-deductible. The advantage of a Roth IRA lies in its tax-free growth and tax-free withdrawals in retirement, provided certain conditions are met.

A custodial Roth IRA is typically established for minors, with an adult managing the account until the child reaches the age of majority, often 18 or 21, depending on the state. The power of compounding interest over many decades can lead to substantial growth within a Roth IRA, making it an effective tool for long-term wealth accumulation. Contributions to a Roth IRA can be withdrawn at any time, tax-free and penalty-free, as they were made with after-tax money.

Withdrawals of earnings from a Roth IRA are tax-free and penalty-free after age 59½ and if the account has been open for at least five years. However, there are exceptions for early withdrawals of earnings without penalty, even if the five-year rule is met. For instance, up to $10,000 in earnings can be withdrawn penalty-free over a lifetime for a first-time home purchase, provided the account has been open for at least five years. Additionally, earnings can be withdrawn for qualified education expenses without incurring the 10% early withdrawal penalty, though these earnings would be subject to ordinary income tax.