If you are planning to make gifts to build the future savings of children or grandchildren, it's important to select the right financial account. We're not talking about saving for future college costs. The goal here may be to fund financial accounts for children that they can later use toward the down payment on their first home or to give them a head start on their retirement.
The basic issue with investment accounts for children is that, generally, individuals under the age of majority, which, depending on the state, is either age 18 or age 21, are not permitted to directly own certain types of financial accounts. But there are several account types that adults can open to use to accumulate savings and invest for children. Here are a few options:
UTMA/UGMA Accounts -- If the goal is to buy and sell securities in a brokerage account for the benefit of a minor, then you'll need to open a special type of account called a Uniform Transfers to Minors Act (UTMA) or Uniform Gifts to Minors Act (UGMA) account. The version you choose depends on the laws of your state. Under this type of account registration, the account owner(and custodian) is an adult (typically a parent) and the child is the beneficial owner. When the child reaches age 18 (or 21, depending on state law), then the account should be legally converted into sole ownership in the child's name.
Investment income from these accounts can have some favorable tax breaks. Assuming the child has no other income and is under age 19 (or under age 24 and a full-time student), the first $1,000 of investment income is tax free. The next $1,000 of investment income is taxed at a rate of 10%. Investment income in excess of $2,000 is included in the parents taxable income and thus taxed at the parents' top marginal tax rate. The tax on the income in excess of the $2,000 threshold is the so-called kiddie tax. If the child is 19 and not a student, or 24 regardless of student status, then all income is reported on the child's own tax return.
Roth IRA -- Children can open and contribute to a Roth IRA as long as they have wage income, regardless of their age. Contributions can be invested in stocks or mutual funds, and distributions after retirement are tax-free. These also allow for tax-free withdrawals of contributions and penalty-free withdrawals of earnings when taking money out for the first-time purchase of a home. Up to $5,500 in annual contributions to a Roth IRA is allowed. If your kids have any taxable earnings in 2013 and you want to give them a head start on the future purchase of a home or their retirement savings, then help out by opening and making a contribution to their Roth IRA.
Grantor Trust -- Individuals who want to give their children or grandchildren larger financial gifts but want to maintain some control as to how the money is managed and when the children receive it should consider what's called a Grantor Trust. Under these trusts, parents specify a trustee and how the money contributed is to be used for the child's education, care, etc. The person setting up the trust can make gift-tax-free contributions of up to $14,000 in 2013 into a trust for each child named as the beneficiary. This most common use for this type of trust is for estate tax-planning purposes.