This holiday, give your kids an investing head start

It's getting to that time again when parents are hearing about what holiday gifts their children want. But this Christmas, our daughter will get a present she didn't ask for and doesn't particularly want: an investment account to help her learn about the stock market.

Research shows that most financial literacy education doesn't work. The exception is the Stock Market Game, where students create and track a simulated portfolio. The game strengthens research and math skills while boosting scores on financial literacy exams.

The game's major flaw is that it is a game, meant to be played for the short term. It can encourage kids to take big gambles using play money. Our daughter will get real money -- $500, roughly equal to what she'll earn this year from a dog-sitting business -- and our suggestions for taking a longer-term approach to investing.

Why is it so important to do this now?

"To get kids into the investing habit early -- and hope it sticks!" declares Janet Bodnar, editor of Kiplinger magazine and author of "Raising Money Smart Kids: What They Need to Know about Money and How to Tell Them."

And of course, you needn't limit the gift of money smarts to the holiday season. If you're interested in encouraging your kids to learn about investing, economics and the market, here are some questions to ask first.

What kind of account should we use?

We're setting up a custodial Roth IRA for our daughter because her self-employment earnings qualify her to contribute and we want her to understand the importance of saving for retirement starting with her first job.

If your child doesn't have earned income, you can open a custodial account under your state's Uniform Transfers to Minors Act or Uniform Gifts to Minors Act rules. On small accounts, you'll pay tax at the child's rate on a custodial account, but investments and other unearned income above a certain limit ($2,100 in 2015) typically is taxed at your rate, thanks to the kiddie tax.

Also, custodial accounts can really hurt college financial aid, so if you expect to get any need-based aid, you should spend the money before the child's junior year in high school. You have to do so according to custodial rules, which typically require the money be spent on something that benefits your child (tutoring, a computer, test prep) but that you're not already obligated to provide (food, clothing, shelter).

With any type of custodial account, the money is legally the child's. She can gain control of the account when she reaches the age of majority in her state (in California, the default age is 18).

If you're concerned about custodial account rules or the kiddie tax -- or about your kid blowing the money someday -- you can simply open a brokerage account in your own name and use it to teach your child about investing.

How should I handle fees?

Buying one company's stock has advantages and pitfalls. Kids may get more excited about a company they recognize than an index full of names they don't. Buying individual stocks, though, can be costlier. While many discount brokerages offer commission-free purchases of mutual funds and exchange-traded funds (ETFs), buying stocks typically costs $7 to $10 per trade. Then there's the issue of diversification, which I'll get to in a moment.

Before you open an account, you'll also want to check out how much you need to invest to start and whether you'll incur other account fees.

Schwab, for example, has a $100 minimum for custodial accounts, including custodial IRAs. Vanguard has a $1,000 minimum for its target-date funds and a $3,000 minimum otherwise. Fidelity has a $2,500 minimum for custodial accounts but no minimum for a custodial IRA. TD Ameritrade, eTrade, Scottrade and Capital One Investing (formerly known as ShareBuilder) have no account minimums. But brokerages with no minimums typically have outgoing transfer fees of $50 to $75, which could nick you if your plan is to build up your account in order to transfer it to a brokerage with higher minimums.

What philosophy do I want to teach?

Buying individual stocks may be fun, but it's not the best long-term approach to investing. Investors do better with very low cost, well-diversified portfolios. That would dictate investing in index funds or ETFs designed to mimic market benchmarks.

You can split the difference, as we are, by putting the bulk of the money in a broad market ETF and then letting your kid pick a stock to buy. It's kind of like making sure they eat their vegetables before they have dessert.

"If you have a diversified portfolio," said Bodnar, "then you can take a flyer on a stock or two."

  • Liz Weston

    Liz Weston is a columnist at NerdWallet, a personal finance website, and author of "Your Credit Score." Email: lweston@nerdwallet.com. Twitter: @lizweston.