What to Invest in When You Are Under 18

Investing for individuals under 18 years of age requires an adult to establish and manage accounts on their behalf, as minors generally lack the legal capacity to enter into investment contracts directly. This ensures compliance with legal frameworks designed to protect minors. Starting early with investments allows for compounding to build wealth over an extended period. This also fosters financial literacy and responsibility from a young age, setting a foundation for future financial independence.

Account Types for Minor Investments

Custodial accounts, established under either the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA), are common vehicles for investing on behalf of a minor. An adult, known as the custodian, opens and manages the account for the minor’s benefit until the minor reaches the age of majority, typically 18 to 21 years. Funds placed into these accounts are considered irrevocable gifts to the minor. The custodian has a fiduciary duty to manage the assets prudently.

A 529 plan offers another tax-advantaged option designed to save for future education expenses. An account owner, often a parent or grandparent, establishes the plan and designates a minor as the beneficiary. The account owner maintains control over the assets and can change the beneficiary to another eligible family member.

Contributions to a 529 plan grow tax-deferred. Qualified withdrawals for higher education expenses, such as tuition, fees, books, supplies, and room and board, are tax-free at the federal level. Up to $10,000 per year per beneficiary can also be used for qualified elementary or secondary school tuition expenses.

For minors with earned income from employment, a Custodial Roth IRA can be a suitable investment vehicle. A parent or guardian can open a Roth IRA in a custodial capacity. Contributions to a Custodial Roth IRA are limited to the lesser of the minor’s earned income for the year or the annual IRA contribution limit, which is $7,000 for 2024. These contributions are made with after-tax dollars, allowing the investments to grow tax-free. Qualified withdrawals in retirement, typically after age 59½ and provided the account has been open for at least five years, are also tax-free.

Suitable Investment Options for Minors

Stocks represent ownership shares in a company and offer potential for long-term growth, making them suitable for minors with a long investment horizon. As a company performs well, its stock value can increase, and some companies pay dividends. Investing in individual stocks carries higher risk than diversified options, as a single company’s performance can be volatile.

Exchange-Traded Funds (ETFs) provide diversification by holding a basket of various assets, such as stocks, bonds, or commodities. ETFs trade on stock exchanges throughout the day, similar to individual stocks. They offer a cost-effective way to gain exposure to broad market segments or specific industries.

Mutual funds are professionally managed portfolios that pool money from many investors to purchase a diversified collection of securities. They offer diversification and professional management, though they may have higher fees compared to some ETFs.

Bonds represent a loan made to a government entity or a corporation, providing a fixed income stream through interest payments. They are considered less volatile and lower-risk than stocks, making them a stable component of a diversified portfolio. Bonds mature at a specific date, returning the original principal amount to the investor.

Savings accounts and Certificates of Deposit (CDs) are lower-risk options suitable for short-term savings goals or funds requiring high liquidity. Savings accounts offer easy access to funds and earn a modest interest rate. CDs require money to be held for a fixed period in exchange for a higher interest rate than a traditional savings account. While not offering the growth potential of stocks or funds, they provide capital preservation and predictable returns.

Important Considerations for Minor Investments

Understanding the “Kiddie Tax” rules is important for custodial accounts like UGMA/UTMA. The Kiddie Tax applies to a minor’s unearned income, including investment income such as dividends, interest, and capital gains. For 2024, if a minor’s unearned income exceeds $2,600, a portion may be taxed at the parent’s marginal income tax rate instead of the minor’s lower rate. The first $1,300 of unearned income is exempt from tax, and the next $1,300 is taxed at the child’s tax rate. Any unearned income above $2,600 is then taxed at the parent’s rate, potentially increasing the overall tax liability.

A characteristic of UGMA/UTMA accounts is the transfer of control to the minor upon reaching the age of majority. The minor gains full legal control and access to all assets held within the custodial account. This transfer is automatic and cannot be prevented by the custodian or the original donor, meaning the minor can use the funds for any purpose they choose, not just those originally intended.

The impact of minor investments on future financial aid eligibility, particularly for federal student aid through the Free Application for Federal Student Aid (FAFSA), is another consideration. Assets held directly in the minor’s name, such as those in an UGMA/UTMA account, are assessed at a higher rate when calculating the Expected Family Contribution (EFC). These assets can be assessed at up to 20% of their value. In contrast, assets held in a parent-owned 529 plan are assessed at a lower rate, 5.64% of their value, as they are considered parental assets. This difference in assessment rates can influence the amount of financial aid a student may qualify for.