5 Smart Ways to Invest for Your Grandchildren

You want to invest for your grandchildren’s future and financial success, but how?   What types of accounts should you use?  Which investments make the most sense?  How will it affect your grandchildren’s financial aid for college?  When will your grandchildren gain access to the funds?  How will it affect your grandchildren’s taxes?  Helping out your grandchildren is an act of kindness. Before you give them cash or open an account for them, it’s important to understand how that might affect your future, as well as your grandchildren’s.   Opening one type of account instead of another may have a significant impact on taxes, when they gain access to the funds, and how they can be used without penalties.   Sometimes the combination of a few different types of accounts can be the most effective way to invest for your grandchildren.   Let’s discuss how to get your grandchildren involved with investing, how much you can give, and how I would personally invest if I had grandchildren.   Your Learning Guide  hide  1. When Does the Grandchild Gain Access to the Investment? 2. 5 Types of Accounts to Invest for Your Grandchildren 2.1. 1. 529 Plans 2.1.1. Prepaid Tuition Plans 2.1.2. College Savings Plans 2.2. 2. Custodial Roth IRA 2.3. 3. Custodial Brokerage – UTMA/UGMA 2.4. 4. TreasuryDirect 2.5. 5. Coverdell Education Savings Account 3. Types of Investments 3.1. Individual Stocks 3.2. Exchange Traded Funds (ETFs) 3.3. Mutual Funds 3.4. Savings Bonds 3.5. Certificate of Deposits (CDs) 4. How to Get Your Grandchildren Involved 5. How Much to Give 6. How I Would Invest if I Had Grandchildren 7. Final Thoughts – My Question for You When Does the Grandchild Gain Access to the Investment?  Before I tell you the types of accounts, how they affect taxes, and the types of investments you can use, you should consider when you want your grandchildren to gain access to the investment.   Do you want them to gain full access when they turn age 18? What about age 21? Do you want to control when you turn it over?   If you do a great job saving, they might have tens of thousands, hundreds of thousands of dollars, or more available to them.   If you are like most people, you may not want your grandchildren getting their hands on a big pile of money the day they can legally gamble or the day they can have their first alcoholic beverage.   It’s important to keep this in mind because when you first start out, your grandchild may not even be one year old yet, and the amount you contribute may seem insignificant; however, if you compound your investment over 18 years, the account balance may look very different by the time they gain access.   You may want to consider giving different amounts to a few accounts to spread out who controls the investment, how they affect college financial aid, and when your grandchild gains access to the account.   5 Types of Accounts to Invest for Your Grandchildren Fortunately, or unfortunately, depending on how you look at it, there are many different types of accounts you can use to invest for your grandchildren.   Let’s go through each, paying close attention to the types of investments available, who controls it, when your grandchildren may gain control, and how it affects taxes.   1. 529 Plans 529 plans allow you to save in a tax-advantaged way for future educational costs.   Although you don’t receive a federal tax deduction for contributions to a 529 plan, certain states do allow state income tax deductions.   The benefit of a 529 plan is that earnings grow-tax free and withdrawals are tax-free if used for qualified educational expenses, such as tuition, fees, and other expenses that are required for enrollment.   There are two types of 529 plans: prepaid tuition plans and college savings plans.   Prepaid Tuition Plans Prepaid tuition plans allow you to pay for future college costs today.   Instead of a 529 plan where the money is invested, prepaid tuition plans allow you to buy a quarter or a semester of college today to be used at a future date.   Although many people look at prepaid tuition plans as a guarantee, it’s important to know that some states have a formal guarantee where the prepaid tuition plan is backed by the full faith and credit of the state, where as other states do not offer any guarantees.   Even if your grandchild does not go to your state’s public schools, you may be able to use the prepaid tuition plan at other universities, but it may not fully cover the cost. For example, some prepaid tuition plans may only pay an amount to another university that is equal to the average tuition at your state’s public universities.   Types of Investments: None because you typically buy “units” or “credits” that pay for quarters or semesters of college in the future.   Control: As the grandparent, you can own the plan and control it while making your grandchild the beneficiary.   Age Grandchild Gains Control: Never. You control when you pay the “units” or “credits” to the school.   Taxes: Tax-free for qualified education expenses.  College Savings Plans College savings plans also allow you to save in a tax-advantaged way for future college or private tuition costs, but instead of buying “units” of tuition, you invest money that can be used for qualified educational expenses later.   While each state has a 529 college savings plan, you don’t have to use your state’s 529 plan. In fact, if your plan has high expenses and bad investment choices, you may want to use another state’s 529 plan. I’ve seen situations where it may make sense to use another state’s 529 plan even if you receive an income tax deduction for contributions to your state’s 529 plan.  For example, if you received a tax deduction equivalent to a $300 savings in tax, but your state plan had fees and investment expenses of 1% while another state had fees and investment expenses of 0.1% and you had $50,000 invested, your state plan costs $500 per year versus $50 for the other. Even after the $300 tax deduction, you don’t come out ahead with your state plan.   This is why it’s important to pay attention to the total costs, after any tax deduction, to decide which state plan to use.   The benefit of 529 college savings plans is that you get to choose the plan, control the investments, and decide when to make distributions for college or private school tuition.   Types of Investments: Limited by what the plan offers. Some plans offer enrollment date, static, or balanced funds.   Control: As the grandparent, you can own the plan and control it while making your grandchild the beneficiary.   Age Grandchild Gains Control: Never. You control when you want to issue a check to the qualifying educational institution.   Taxes: Tax-free for qualified educational expenses.   529 plans - prepaid tuition plans vs. college savings plans for how to invest for your grandchildren 2. Custodial Roth IRA A custodial Roth IRA is a way to save for a minor’s future retirement costs.   It’s similar to a normal Roth IRA, but since a minor can’t legally have their own account, a custodian, such as a grandparent, manages the account until the grandchild reaches age 18 or 21, depending on the state.   Similar to a Roth IRA, your grandchild must have earned income to be eligible for someone to make contributions to a custodial Roth IRA. If your grandchild has no earned income, contributions can’t be made to the account. You also can’t exceed the maximum annual contribution limit, which in 2022, is $6,000. Roth IRAs also have income limitations, but since I’m assuming your grandchild is young, they may not face this issue. It’s something to be aware of as they get older though.  Contributions are made after tax, but growth and future withdrawals are tax-free if made after age 59 ½.   Custodial Roth IRAs are great options as soon as your grandchild starts working. For example, if your grandchild gets a summer job where they earn $1,000, you could make a $1,000 contribution to a custodial Roth IRA.   If your grandchild is entrepreneurially-minded and decides to mow lawns or open a lemonade stand, those earnings can count, too. It’s okay that they don’t receive a W-2. Self-employment earnings count.   If the income isn’t high enough to need to file a tax return, you may want to keep a log of the earnings in case it is ever questioned.   Although these small amounts of money may not sound like much, setting up a custodial Roth IRA and making contributions each year can translate to significant money later in life. For example, if your grandchild is age 10 and you make a $2,500 contribution annually for 8 years, they never make another contribution, and your grandchild allows the contributions to compound for 50 years at 7%, it would grow to approximately $503,460 at age 60.   The downside to a custodial Roth IRA is that your grandchild will get full access to the account when they become an adult, usually age 18 or 21.   Types of Investments: Most custodians allow you to invest in any stocks, ETFs, mutual funds, bonds, or other types of investments.   Control: As the custodian, you control the account until they turn age 18 or 21, and then a Roth IRA is opened in their name, where they gain full control.   Age Grandchild Gains Control: Typically, age 18 or 21, depending on the state.   Taxes: Earnings and withdrawals are tax-free if made after age 59 ½.   3. Custodial Brokerage – UTMA/UGMA A custodial brokerage account, such as an UTMA or UGMA, is a way to invest for your grandchild without limits on contributions by earned income or how the money can be used.   Custodial brokerage accounts provide lots of flexibility because you can use them for anything. Plus, they are a great way to get a grandchild involved with investing at a young age, which I’ll talk about in more detail later.  You can make any size contribution to a custodial brokerage account you want, but you should be aware of gift tax rules. Since the custodial brokerage is technically owned by your grandchild, when you deposit money into a custodial account, you are making a gift. If you give more than the annual exclusion amount, which is $16,000 in 2022, you may need to file a gift tax return. Please keep in mind that the total gift amount includes all gifts in the year, which could be Roth IRA contributions you make, vacations you pay for, or birthday money.  Since the custodial account is technically owned by your grandchild, special tax rules apply. The income created by the investments in the account, such as dividends, interest, or earnings, are taxed at different rates as long as the grandchild is younger than age 18.  In 2022, the first $1,150 is tax free and the next $1,150 is taxed at the child’s tax rate. Any income over $2,300 is taxed at the parent’s rate.   These tax rules are known as the Kiddie Tax. The Kiddie Tax also can apply to full-time students between the ages of 19 and 23.   These are important to know and plan around because if you need to recognize capital gains by selling an investment within the account, your grandchild may have a hefty tax burden.  On an annual basis, the tax consequences should be fairly low if capital gain distributions are minimal and you don’t sell anything for a capital gain. For example, if you have $50,000 invested with an average yield of 3%, that should produce about $1,500 in income – ordinary dividends, qualified dividends, or interest, depending on the investment and holding time.   The downside to these types of accounts is they count more heavily against financial aid. Any accounts in their name contribute 20% to the expected family contribution (EFC) compared to parental assets that only contribute 5.64%.   The other disadvantage is if you have significant growth and need to recognize capital gains by selling an investment, you may create a capital gain tax liability. If the grandchild does this while they are in college receiving aid, the income created by the selling can also decrease their potential financial aid.   One other drawback to a custodial brokerage account is that they turn over to your grandchild at age 18 or 21. If you do a great job saving, they may have a decent sum of money that they can use for anything.   Types of Investments: Most custodians allow you to invest in any stocks, ETFs, mutual funds, bonds, or other types of investments.   Control: As the custodian, you control the account until they turn age 18 or 21, and then a brokerage account is opened in their name, where they gain full control.   Age Grandchild Gains Control: Typically, age 18 or 21, depending on the state.   Taxes: Interest income taxable as ordinary income. Capital gains and qualified dividends taxed at the long-term capital gains rate (0%, 15%, or 20%). Subject to Kiddie Tax.   4. TreasuryDirect  The TreasuryDirect is “the first and only financial services website that lets you buy and redeem securities directly from the U.S. Department of the Treasury in paperless electronic form.”   I hesitate to even mention the TreasuryDirect as a type of account because it’s more of a website that facilitates purchases, but it’s also the only place you can buy Series I and EE Savings Bonds.   From my perspective, that makes it a type of account.   Series I savings bonds are popular right now because inflation is high and the rate of return the bonds are offering are high relative to anything else in the bond market. As of this writing, it is 4.81% over the next six months.   Series EE savings bonds have extremely low rates (0.10% as of this writing), but they have a guarantee that the bonds will double in value if kept for 20 years. This equates to approximately a 3.526% annual rate of return.   Both Series I and EE savings bonds have a maximum purchase amount of $10,000 per year. Series I savings bonds also allow $5,000 of additional purchases in paper form with your tax refund.   The downside to the TreasuryDirect is that the website is clunky, and the long-term rates of return may be low compared to other types of investments.   Types of Investments: Treasury Bills, Notes, Bonds, Inflation-Protected Securities (TIPS), Floating Rate Notes, and Series I and EE Savings Bonds.   Control: You have complete control unless you open a custodial account.   Age Grandchild Gains Control: Never, unless you open a custodial account, in which case it is age 18.   Taxes: Typically, interest income that is taxed as ordinary income, but it depends on the investment purchased. With the Series I and EE savings bonds, you may be able to defer reporting the interest until you cash the bond, give up ownership, or the bond matures. Plus, with Series I and EE savings bonds, there are special rules that they can be used tax-free for college if certain conditions are met.   Savings bonds - series I vs. series ee 5. Coverdell Education Savings Account Coverdell ESAs allow you to save in a tax-advantaged way for your grandchildren’s education, but they come with lower contribution and income eligibility limits.   There is a $2,000 per year contribution limit for each grandchild, meaning if another family member wants to open and contribute to an account, the sum of all contributions cannot exceed $2,000 a year.   In 2022, you also can’t contribute to a Coverdell ESA if your adjusted gross income is over $220,000 as a married couple or $110,000 for single filers. There is a phaseout of how much you can contribute between $190,000 and $220,000 for a married couple or between $95,000 and $110,000 for single filers.   Earnings grow tax free and withdrawals are tax-free as long as they are spent for qualified educational expenses.   One benefit a Coverdell ESA has over a 529 plan is that the tax-free withdrawals can be used on qualified expenses between kindergarten through college, whereas a 529 plan has a $10,000 limit that can be used on primary or secondary school tuition.   One downside to a Coverdell ESA is that you can’t make contributions after age 18, and the money needs to be fully distributed by the time the beneficiary of the account reaches age 30 or transferred to another member of the beneficiary’s family who is under age 30, whereas a 529 plan can continue past that age.   Coverdell ESAs are similar to 529 plans when it comes to college financial aid eligibility. Usually 5.64% of the assets are counted in the expected family contribution.   Types of Investments: Most custodians allow you to invest in any stocks, ETFs, mutual funds, bonds, or other types of investments.  Control: You retain control as the custodian of the account.   Age Grandchild Gains Control: Age 30.  Taxes: Tax-free for qualified educational expenses. If your grandchild turns 30, and the account is distributed, the earnings are subject to tax, as well as a 10% penalty, to the grandchild.   Types of Investments The types of investments you decide to use for your grandchildren should depend on when the funds may be used.  I generally think of cash as being available for use in the next year or two. I think of bonds as being available for years 2-7 and stocks for years 7+.   For example, if you have a grandchild starting college next year, it may not make sense to invest funds into a 100% stock portfolio in a 529 plan.   The real benefit of a 529 plan is years or decades of tax-free growth. Plus, it normally doesn’t make sense to put money at risk in stocks if you know it will be used in the next year or two. What if the stock market declines 30%?   Know your timeframe for spending from cash, stocks, and bonds Let’s look at the different investments available and give examples of when they might make sense for your grandchild.   Individual Stocks I’m a huge advocate of diversification, so by nature, I don’t normally advocate for buying individual stocks; however, in the case of young grandchildren, individual stocks can be a great way to get them interested and involved with investing.   While I’d love to tell every grandchild, “Here is this really cool low cost, globally diversified exchange traded fund with thousands of stocks from around the world” and have them magically be interested in investing, I recognize that’s not how it works.   Most grandchildren are only going to care about investing if you can buy them a share of Disney, Mattel, McDonalds, Activision Blizzard, Microsoft, or another publicly traded company they recognize from something they use or love.   I got started investing at a young age because I got to research and buy companies I was interested in owning. An ETF or mutual fund wasn’t going to cut it.   While I wouldn’t advocate for owning a portfolio of all individual stocks, I do think a custodial Roth IRA or a Custodial Brokerage account with a few individual stocks can engage grandchildren, give them the opportunity to see how markets fluctuate (and how much individual stocks can fluctuate), as well as lessons about valuation. If they can learn early on that the best companies with the most attractive stories can still be poor investments if you pay too much for them, it is better than learning that lesson late in life with more money and less time to make up for mistakes.   Exchange Traded Funds (ETFs) ETFs are boring, but they are low cost, tax-efficient, and can get your grandchildren diversified without much complexity.   ETFs are like a candy wrapper. You can use the wrapper to put just about anything inside.   ETFs can own stocks or bonds. They can be broadly diversified or own a sector. They can own US, international, or emerging market companies.   I like ETFs, particularly for custodial brokerage accounts, because they are generally more tax-efficient than mutual funds.   In a tax-advantaged account, like a 529 plan, custodial Roth IRA, or Coverdell ESA, it’s less important whether a mutual fund or ETF is used because you already have a tax shelter from the account.   Another benefit of ETFs is they tend to be lower cost than mutual funds.   ETFs are unlikely to excite your grandchild, but they could serve as a core part of your investment policy statement.   Mutual Funds Like ETFs, mutual funds are also boring, but they can provide diversification at a low cost.   Mutual funds can own any combination of stocks or bonds, depending on what index the fund is tracking or what the manager decides to invest in.   You’ll usually find mutual funds in 529 plans and have the option to invest in them within a custodial Roth IRA, custodial brokerage, or Coverdell ESA.   I recommend looking at the expense ratio to see how expensive a fund is to own compared to other funds in the same category (i.e. large cap US companies). Mutual funds can be cheap, but they can also be very expensive. Each category has different levels of what is expensive. For example, mutual funds investing in large cap US companies generally have lower expenses than mutual funds investing in emerging markets because it’s an easier market to access and trade.   If you are investing in mutual funds with a custodial brokerage account, you should pay attention to the tax efficiency of the fund. Also, I would be wary of using a target date fund within a custodial brokerage account. Vanguard shareholders were caught off guard in 2021 with large capital gain distributions and a surprise tax bill.   Savings Bonds As I mentioned earlier, Series I savings bonds have an attractive rate of return right now, but long-term, that may not hold, particularly because the return right now is only coming from inflation.  I could see using Series I savings bonds if someone needs to go to college in a year or two. They offer attractive rates of return, but do have a one year lock up.   Series EE savings bonds have very low interest rates, but if you plan on holding it for 20 years, you can double your money. That’s not very attractive if you do a quick analysis using the rule of 72.   The rule of 72 is a quick way to estimate the number of years it takes to double your money given a rate of return.  You can estimate the number of years it takes to double your money by dividing 72 by your annual rate of return.  For example, if you expected to earn 7% per year in another investment, it would take approximately a little more than 10 years (72 divided by 7) to double your money.   Rule of 72 While nobody knows what future returns will be and it depends on your investment, a balanced portfolio of stocks and bonds generally has done better than the rate of return of a Series EE saving bond.   If someone were a very conservative investor that felt very uncomfortable with market risk, a Series EE saving bond might make sense for them.   Certificate of Deposits (CDs) CDs are low risk, low returning investments, but I want to include them because the closer you get to your grandchild needing the money, the more conservative the portfolio normally should be.  For example, if your grandchild isn’t going to use the money you are investing for 20 years, you may have the ability to take more risk with it and ride out the market’s ups and downs.  If your grandchild is going to use your investment in the next year, I’d have a tough time justifying having any of that money in risky assets like stocks.   That’s where a CD, treasury bill, or even cash in the bank can be appropriate.   This is particularly important to pay attention to for college funds. For families who are selecting their investments or even if you have money in a target date enrollment funds, it’s important to know how you are invested.   If you encounter a market downturn and you need the money you have saved for college, you may be forced to make some really hard decisions if you no longer have as much as you needed for college.   Again, the investment risk should be one consideration when deciding which types of investments to use. If the risk doesn’t align with the time frame for using the funds, you may have to make tough decisions later.   How to Get Your Grandchildren Involved Grandparents and parents take different approaches to how involved they want their grandchildren and children involved with money and investing.   My own bias is that I tend to be on the side of more disclosure is better. I don’t believe money should be a taboo topic and when I’ve seen families be secretive about money, it sometimes leads to strange family dynamics, a terrible relationship with money, and an inability to handle finances later in life.   I’m not advocating for telling your five year old grandchild you have $20,000 saved for them, but I do believe you can approach money and get them involved differently as they age.   For example, maybe when they are young, you use part of an investment to make a charitable contribution and have them pick the charity. You can explain how the earnings in the account grew, and it’s good to give back.  Maybe when they are 10, you can have them pick an individual stock they like and invest into it within a custodial brokerage or custodial Roth IRA account.   As they grow older, you could have them read a book or a website about investing and have them make a plan for investing 25% of an account while you control the other 75%. Over time, perhaps those percentages can change to give them more control.   Each grandchild is different, which means the approach needs to be different. In general, I’ve found individual stock picking when they are younger is helpful, but as they age, bringing them around to the idea of diversification and boring investing is important.   Something else I’ve seen be successful is offering matching funds. You could promise to match any retirement or custodial brokerage deposits they make with an equal amount from you. For example, if they save $1,000 to a custodial Roth IRA, but they had at least $2,000 in earnings, you could match the $1,000. If they didn’t have enough in earnings, you could match it towards a 529 plan or custodial brokerage account.   How Much to Give Ah, yes. The question that will likely live until the end of civilization. How much do I give my grandchild?   If you give too much, they might be spoiled and have an incentive not to work as hard. If you don’t give enough, they might be at a disadvantage to others.   It’s a difficult balance.   Something I’ve found interesting over the years is that grandparents who are now wealthy, but were not wealthy growing up, want to give as much as possible, but also tell me how part of their success is due to not having resources and that provided motivation to work harder to gain wealth.   I’m not sure what you can do with that information, but I think it’s worth pointing out that what people partially attribute to their success, they sometimes deny others.   Whether you want to use your annual gift tax exclusion or superfund a 529 plan, you have plenty of options to give thousands or tens of thousands of dollars per year.   Something to keep in mind is when your grandchild gains access to the money. If you do a phenomenal job saving money into a custodial Roth IRA and it’s worth $50,000 when they turn age 18, they can technically do whatever they want with that account when they receive it.   I often see families do a little saving to a few different types of accounts to limit the amount of access a grandchild gets at age 18 or 21. Usually, I see larger balances in the 529 plan, followed by a custodial brokerage, and then the custodial Roth IRA.   How I Would Invest if I Had Grandchildren I don’t have grandchildren, but if I did and had more than enough for my lifetime, this is what I would do.   I would fully fund their custodial Roth IRA as early as I could with as much as I could. Time is one of the greater opportunities young people have for compounding.   Even if that account is worth more than most people want an 18 year old to have, I would be willing to take that risk. Of course, there is always the exception that if my grandchild was displaying habits that were not in line with being able to handle money well, I could stop or pause the contributions.   Along the way, I’d do my best to teach them about investing, get them involved, start making decisions about the account, give them view only access, and move from individual stocks to boring ETFs for the majority of the account as they age.   Next, I’d fund 529 plans for my grandchild to a 50% or a 75% level. Again, this is assuming I have more than I need. For example, if school was going to cost $200,000 over four years, I’d aim to have $100,000 to $150,000 in a 529 plan.   I don’t aim for 100% funding because you never know what sort of scholarships a grandchild may get or how expensive a school they decide to attend. There is also less flexibility with a 529 plan, unless you have many other grandchildren within the same family you can move the funds to.   This would be 100% boring money. It would be ETFs or mutual funds tracking an index.   Finally, I’d set aside some money in a custodial brokerage account. I’m not providing an amount because this is where I’d need to tailor it to the grandchild. I could only get so much money into a Roth IRA before they turn 18. It’s usually not enough to totally wreck someone’s life if they gain access and blow it all in a day.   I’ve seen custodial brokerage accounts balances large enough where when they are turned over, they could destroy someone’s life if the grandchild is not in a space to manage the account responsibly.   This is another account where I’d attempt to get the grandchild involved, research individual stocks, and move to a more ETF-focused account as they get older, but give them a part of the portfolio they could continue investing in individual stocks, such as 10%.   Please keep in mind that personal finance has the word personal in front of it for a reason. Each family is different. Everyone has different values. This is what I would do, but this may not work for you.   Plus, if I had grandchildren, I may change my mind entirely! You never know until you go through it and only in hindsight might you know what would have been best.   Final Thoughts – My Question for You Gifting and investing for your grandchild is a wonderful act of kindness.   Whether you use a 529 plan, custodial Roth IRA, custodial brokerage, TreasuryDirect, or Coverdell Education Savings Account, they each offer their own advantages and disadvantages. Some provide more flexibility, such as custodial brokerage, while others provide more tax advantages, such as a 529 plan.   The other key decision to make is what types of investments you are going to use. Some of this depends on the time frame for using the funds, while another piece of the puzzle is how you want to engage your grandchild. It’s even more challenging because the type of investment may need to change over time to teach good investing habits.   Whether you give $1 or $1,000,000+, having a plan about how you are going to give, how much you plan to give, and what types of investments you are going to use is important.   I’ll leave you with one question to act on.   When will you create a giving plan for your grandchildren?

21.5 MIN READ

You want to invest for your grandchildren’s future and financial success, but how? 

  • What types of accounts should you use? 
  • Which investments make the most sense? 
  • How will it affect your grandchildren’s financial aid for college? 
  • When will your grandchildren gain access to the funds? 
  • How will it affect your grandchildren’s taxes? 

Helping out your grandchildren is an act of kindness. Before you give them cash or open an account for them, it’s important to understand how that might affect your future, as well as your grandchildren’s. 

Opening one type of account instead of another may have a significant impact on taxes, when they gain access to the funds, and how they can be used without penalties. 

Sometimes the combination of a few different types of accounts can be the most effective way to invest for your grandchildren. 

Let’s discuss how to get your grandchildren involved with investing, how much you can give, and how I would personally invest if I had grandchildren. 

When Does the Grandchild Gain Access to the Investment? 

Before I tell you the types of accounts, how they affect taxes, and the types of investments you can use, you should consider when you want your grandchildren to gain access to the investment. 

Do you want them to gain full access when they turn age 18? What about age 21? Do you want to control when you turn it over? 

If you do a great job saving, they might have tens of thousands, hundreds of thousands of dollars, or more available to them. 

If you are like most people, you may not want your grandchildren getting their hands on a big pile of money the day they can legally gamble or the day they can have their first alcoholic beverage. 

It’s important to keep this in mind because when you first start out, your grandchild may not even be one year old yet, and the amount you contribute may seem insignificant; however, if you compound your investment over 18 years, the account balance may look very different by the time they gain access. 

You may want to consider giving different amounts to a few accounts to spread out who controls the investment, how they affect college financial aid, and when your grandchild gains access to the account. 

5 Types of Accounts to Invest for Your Grandchildren

Fortunately, or unfortunately, depending on how you look at it, there are many different types of accounts you can use to invest for your grandchildren. 

Let’s go through each, paying close attention to the types of investments available, who controls it, when your grandchildren may gain control, and how it affects taxes. 

1. 529 Plans

529 plans allow you to save in a tax-advantaged way for future educational costs. 

Although you don’t receive a federal tax deduction for contributions to a 529 plan, certain states do allow state income tax deductions

The benefit of a 529 plan is that earnings grow-tax free and withdrawals are tax-free if used for qualified educational expenses, such as tuition, fees, and other expenses that are required for enrollment. 

There are two types of 529 plans: prepaid tuition plans and college savings plans. 

Prepaid Tuition Plans

Prepaid tuition plans allow you to pay for future college costs today. 

Instead of a 529 plan where the money is invested, prepaid tuition plans allow you to buy a quarter or a semester of college today to be used at a future date. 

Although many people look at prepaid tuition plans as a guarantee, it’s important to know that some states have a formal guarantee where the prepaid tuition plan is backed by the full faith and credit of the state, where as other states do not offer any guarantees. 

Even if your grandchild does not go to your state’s public schools, you may be able to use the prepaid tuition plan at other universities, but it may not fully cover the cost. For example, some prepaid tuition plans may only pay an amount to another university that is equal to the average tuition at your state’s public universities. 

Types of Investments: None because you typically buy “units” or “credits” that pay for quarters or semesters of college in the future. 

Control: As the grandparent, you can own the plan and control it while making your grandchild the beneficiary. 

Age Grandchild Gains Control: Never. You control when you pay the “units” or “credits” to the school. 

Taxes: Tax-free for qualified education expenses.

College Savings Plans

College savings plans also allow you to save in a tax-advantaged way for future college or private tuition costs, but instead of buying “units” of tuition, you invest money that can be used for qualified educational expenses later. 

While each state has a 529 college savings plan, you don’t have to use your state’s 529 plan. In fact, if your plan has high expenses and bad investment choices, you may want to use another state’s 529 plan. I’ve seen situations where it may make sense to use another state’s 529 plan even if you receive an income tax deduction for contributions to your state’s 529 plan.

For example, if you received a tax deduction equivalent to a $300 savings in tax, but your state plan had fees and investment expenses of 1% while another state had fees and investment expenses of 0.1% and you had $50,000 invested, your state plan costs $500 per year versus $50 for the other. Even after the $300 tax deduction, you don’t come out ahead with your state plan. 

This is why it’s important to pay attention to the total costs, after any tax deduction, to decide which state plan to use. 

The benefit of 529 college savings plans is that you get to choose the plan, control the investments, and decide when to make distributions for college or private school tuition. 

Types of Investments: Limited by what the plan offers. Some plans offer enrollment date, static, or balanced funds. 

Control: As the grandparent, you can own the plan and control it while making your grandchild the beneficiary. 

Age Grandchild Gains Control: Never. You control when you want to issue a check to the qualifying educational institution. 

Taxes: Tax-free for qualified educational expenses. 

529 plans - prepaid tuition plans vs. college savings plans for how to invest for your grandchildren

2. Custodial Roth IRA

A custodial Roth IRA is a way to save for a minor’s future retirement costs. 

It’s similar to a normal Roth IRA, but since a minor can’t legally have their own account, a custodian, such as a grandparent, manages the account until the grandchild reaches age 18 or 21, depending on the state. 

Similar to a Roth IRA, your grandchild must have earned income to be eligible for someone to make contributions to a custodial Roth IRA. If your grandchild has no earned income, contributions can’t be made to the account. You also can’t exceed the maximum annual contribution limit, which in 2022, is $6,000. Roth IRAs also have income limitations, but since I’m assuming your grandchild is young, they may not face this issue. It’s something to be aware of as they get older though.

Contributions are made after tax, but growth and future withdrawals are tax-free if made after age 59 ½. 

Custodial Roth IRAs are great options as soon as your grandchild starts working. For example, if your grandchild gets a summer job where they earn $1,000, you could make a $1,000 contribution to a custodial Roth IRA. 

If your grandchild is entrepreneurially-minded and decides to mow lawns or open a lemonade stand, those earnings can count, too. It’s okay that they don’t receive a W-2. Self-employment earnings count. 

If the income isn’t high enough to need to file a tax return, you may want to keep a log of the earnings in case it is ever questioned. 

Although these small amounts of money may not sound like much, setting up a custodial Roth IRA and making contributions each year can translate to significant money later in life. For example, if your grandchild is age 10 and you make a $2,500 contribution annually for 8 years, they never make another contribution, and your grandchild allows the contributions to compound for 50 years at 7%, it would grow to approximately $503,460 at age 60. 

The downside to a custodial Roth IRA is that your grandchild will get full access to the account when they become an adult, usually age 18 or 21. 

Types of Investments: Most custodians allow you to invest in any stocks, ETFs, mutual funds, bonds, or other types of investments. 

Control: As the custodian, you control the account until they turn age 18 or 21, and then a Roth IRA is opened in their name, where they gain full control. 

Age Grandchild Gains Control: Typically, age 18 or 21, depending on the state. 

Taxes: Earnings and withdrawals are tax-free if made after age 59 ½. 

3. Custodial Brokerage – UTMA/UGMA

A custodial brokerage account, such as an UTMA or UGMA, is a way to invest for your grandchild without limits on contributions by earned income or how the money can be used. 

Custodial brokerage accounts provide lots of flexibility because you can use them for anything. Plus, they are a great way to get a grandchild involved with investing at a young age, which I’ll talk about in more detail later.

You can make any size contribution to a custodial brokerage account you want, but you should be aware of gift tax rules. Since the custodial brokerage is technically owned by your grandchild, when you deposit money into a custodial account, you are making a gift. If you give more than the annual exclusion amount, which is $16,000 in 2022, you may need to file a gift tax return. Please keep in mind that the total gift amount includes all gifts in the year, which could be Roth IRA contributions you make, vacations you pay for, or birthday money.

Since the custodial account is technically owned by your grandchild, special tax rules apply. The income created by the investments in the account, such as dividends, interest, or earnings, are taxed at different rates as long as the grandchild is younger than age 18.

In 2022, the first $1,150 is tax free and the next $1,150 is taxed at the child’s tax rate. Any income over $2,300 is taxed at the parent’s rate. 

These tax rules are known as the Kiddie Tax. The Kiddie Tax also can apply to full-time students between the ages of 19 and 23. 

These are important to know and plan around because if you need to recognize capital gains by selling an investment within the account, your grandchild may have a hefty tax burden.

On an annual basis, the tax consequences should be fairly low if capital gain distributions are minimal and you don’t sell anything for a capital gain. For example, if you have $50,000 invested with an average yield of 3%, that should produce about $1,500 in income – ordinary dividends, qualified dividends, or interest, depending on the investment and holding time. 

The downside to these types of accounts is they count more heavily against financial aid. Any accounts in their name contribute 20% to the expected family contribution (EFC) compared to parental assets that only contribute 5.64%. 

The other disadvantage is if you have significant growth and need to recognize capital gains by selling an investment, you may create a capital gain tax liability. If the grandchild does this while they are in college receiving aid, the income created by the selling can also decrease their potential financial aid. 

One other drawback to a custodial brokerage account is that they turn over to your grandchild at age 18 or 21. If you do a great job saving, they may have a decent sum of money that they can use for anything. 

Types of Investments: Most custodians allow you to invest in any stocks, ETFs, mutual funds, bonds, or other types of investments. 

Control: As the custodian, you control the account until they turn age 18 or 21, and then a brokerage account is opened in their name, where they gain full control. 

Age Grandchild Gains Control: Typically, age 18 or 21, depending on the state. 

Taxes: Interest income taxable as ordinary income. Capital gains and qualified dividends taxed at the long-term capital gains rate (0%, 15%, or 20%). Subject to Kiddie Tax. 

4. TreasuryDirect 

The TreasuryDirect is “the first and only financial services website that lets you buy and redeem securities directly from the U.S. Department of the Treasury in paperless electronic form.” 

I hesitate to even mention the TreasuryDirect as a type of account because it’s more of a website that facilitates purchases, but it’s also the only place you can buy Series I and EE Savings Bonds. 

From my perspective, that makes it a type of account. 

Series I savings bonds are popular right now because inflation is high and the rate of return the bonds are offering are high relative to anything else in the bond market. As of this writing, it is 4.81% over the next six months. 

Series EE savings bonds have extremely low rates (0.10% as of this writing), but they have a guarantee that the bonds will double in value if kept for 20 years. This equates to approximately a 3.526% annual rate of return. 

Both Series I and EE savings bonds have a maximum purchase amount of $10,000 per year. Series I savings bonds also allow $5,000 of additional purchases in paper form with your tax refund. 

The downside to the TreasuryDirect is that the website is clunky, and the long-term rates of return may be low compared to other types of investments. 

Types of Investments: Treasury Bills, Notes, Bonds, Inflation-Protected Securities (TIPS), Floating Rate Notes, and Series I and EE Savings Bonds. 

Control: You have complete control unless you open a custodial account. 

Age Grandchild Gains Control: Never, unless you open a custodial account, in which case it is age 18. 

Taxes: Typically, interest income that is taxed as ordinary income, but it depends on the investment purchased. With the Series I and EE savings bonds, you may be able to defer reporting the interest until you cash the bond, give up ownership, or the bond matures. Plus, with Series I and EE savings bonds, there are special rules that they can be used tax-free for college if certain conditions are met. 

Savings bonds - series I vs. series ee

5. Coverdell Education Savings Account

Coverdell ESAs allow you to save in a tax-advantaged way for your grandchildren’s education, but they come with lower contribution and income eligibility limits. 

There is a $2,000 per year contribution limit for each grandchild, meaning if another family member wants to open and contribute to an account, the sum of all contributions cannot exceed $2,000 a year. 

In 2022, you also can’t contribute to a Coverdell ESA if your adjusted gross income is over $220,000 as a married couple or $110,000 for single filers. There is a phaseout of how much you can contribute between $190,000 and $220,000 for a married couple or between $95,000 and $110,000 for single filers. 

Earnings grow tax free and withdrawals are tax-free as long as they are spent for qualified educational expenses. 

One benefit a Coverdell ESA has over a 529 plan is that the tax-free withdrawals can be used on qualified expenses between kindergarten through college, whereas a 529 plan has a $10,000 limit that can be used on primary or secondary school tuition. 

One downside to a Coverdell ESA is that you can’t make contributions after age 18, and the money needs to be fully distributed by the time the beneficiary of the account reaches age 30 or transferred to another member of the beneficiary’s family who is under age 30, whereas a 529 plan can continue past that age. 

Coverdell ESAs are similar to 529 plans when it comes to college financial aid eligibility. Usually 5.64% of the assets are counted in the expected family contribution. 

Types of Investments: Most custodians allow you to invest in any stocks, ETFs, mutual funds, bonds, or other types of investments.

Control: You retain control as the custodian of the account. 

Age Grandchild Gains Control: Age 30.

Taxes: Tax-free for qualified educational expenses. If your grandchild turns 30, and the account is distributed, the earnings are subject to tax, as well as a 10% penalty, to the grandchild. 

Types of Investments

The types of investments you decide to use for your grandchildren should depend on when the funds may be used.

I generally think of cash as being available for use in the next year or two. I think of bonds as being available for years 2-7 and stocks for years 7+. 

For example, if you have a grandchild starting college next year, it may not make sense to invest funds into a 100% stock portfolio in a 529 plan. 

The real benefit of a 529 plan is years or decades of tax-free growth. Plus, it normally doesn’t make sense to put money at risk in stocks if you know it will be used in the next year or two. What if the stock market declines 30%? 

Know your timeframe for spending from cash, stocks, and bonds

Let’s look at the different investments available and give examples of when they might make sense for your grandchild. 

Individual Stocks

I’m a huge advocate of diversification, so by nature, I don’t normally advocate for buying individual stocks; however, in the case of young grandchildren, individual stocks can be a great way to get them interested and involved with investing. 

While I’d love to tell every grandchild, “Here is this really cool low cost, globally diversified exchange traded fund with thousands of stocks from around the world” and have them magically be interested in investing, I recognize that’s not how it works. 

Most grandchildren are only going to care about investing if you can buy them a share of Disney, Mattel, McDonalds, Activision Blizzard, Microsoft, or another publicly traded company they recognize from something they use or love. 

I got started investing at a young age because I got to research and buy companies I was interested in owning. An ETF or mutual fund wasn’t going to cut it. 

While I wouldn’t advocate for owning a portfolio of all individual stocks, I do think a custodial Roth IRA or a Custodial Brokerage account with a few individual stocks can engage grandchildren, give them the opportunity to see how markets fluctuate (and how much individual stocks can fluctuate), as well as lessons about valuation. If they can learn early on that the best companies with the most attractive stories can still be poor investments if you pay too much for them, it is better than learning that lesson late in life with more money and less time to make up for mistakes. 

Exchange Traded Funds (ETFs)

ETFs are boring, but they are low cost, tax-efficient, and can get your grandchildren diversified without much complexity. 

ETFs are like a candy wrapper. You can use the wrapper to put just about anything inside. 

ETFs can own stocks or bonds. They can be broadly diversified or own a sector. They can own US, international, or emerging market companies. 

I like ETFs, particularly for custodial brokerage accounts, because they are generally more tax-efficient than mutual funds. 

In a tax-advantaged account, like a 529 plan, custodial Roth IRA, or Coverdell ESA, it’s less important whether a mutual fund or ETF is used because you already have a tax shelter from the account. 

Another benefit of ETFs is they tend to be lower cost than mutual funds. 

ETFs are unlikely to excite your grandchild, but they could serve as a core part of your investment policy statement

Mutual Funds

Like ETFs, mutual funds are also boring, but they can provide diversification at a low cost. 

Mutual funds can own any combination of stocks or bonds, depending on what index the fund is tracking or what the manager decides to invest in. 

You’ll usually find mutual funds in 529 plans and have the option to invest in them within a custodial Roth IRA, custodial brokerage, or Coverdell ESA. 

I recommend looking at the expense ratio to see how expensive a fund is to own compared to other funds in the same category (i.e. large cap US companies). Mutual funds can be cheap, but they can also be very expensive. Each category has different levels of what is expensive. For example, mutual funds investing in large cap US companies generally have lower expenses than mutual funds investing in emerging markets because it’s an easier market to access and trade. 

If you are investing in mutual funds with a custodial brokerage account, you should pay attention to the tax efficiency of the fund. Also, I would be wary of using a target date fund within a custodial brokerage account. Vanguard shareholders were caught off guard in 2021 with large capital gain distributions and a surprise tax bill. 

Savings Bonds

As I mentioned earlier, Series I savings bonds have an attractive rate of return right now, but long-term, that may not hold, particularly because the return right now is only coming from inflation.

I could see using Series I savings bonds if someone needs to go to college in a year or two. They offer attractive rates of return, but do have a one year lock up. 

Series EE savings bonds have very low interest rates, but if you plan on holding it for 20 years, you can double your money. That’s not very attractive if you do a quick analysis using the rule of 72. 

The rule of 72 is a quick way to estimate the number of years it takes to double your money given a rate of return.

You can estimate the number of years it takes to double your money by dividing 72 by your annual rate of return.

For example, if you expected to earn 7% per year in another investment, it would take approximately a little more than 10 years (72 divided by 7) to double your money. 

Rule of 72

While nobody knows what future returns will be and it depends on your investment, a balanced portfolio of stocks and bonds generally has done better than the rate of return of a Series EE saving bond. 

If someone were a very conservative investor that felt very uncomfortable with market risk, a Series EE saving bond might make sense for them. 

Certificate of Deposits (CDs)

CDs are low risk, low returning investments, but I want to include them because the closer you get to your grandchild needing the money, the more conservative the portfolio normally should be.

For example, if your grandchild isn’t going to use the money you are investing for 20 years, you may have the ability to take more risk with it and ride out the market’s ups and downs.

If your grandchild is going to use your investment in the next year, I’d have a tough time justifying having any of that money in risky assets like stocks. 

That’s where a CD, treasury bill, or even cash in the bank can be appropriate. 

This is particularly important to pay attention to for college funds. For families who are selecting their investments or even if you have money in a target date enrollment funds, it’s important to know how you are invested. 

If you encounter a market downturn and you need the money you have saved for college, you may be forced to make some really hard decisions if you no longer have as much as you needed for college. 

Again, the investment risk should be one consideration when deciding which types of investments to use. If the risk doesn’t align with the time frame for using the funds, you may have to make tough decisions later. 

How to Get Your Grandchildren Involved

Grandparents and parents take different approaches to how involved they want their grandchildren and children involved with money and investing. 

My own bias is that I tend to be on the side of more disclosure is better. I don’t believe money should be a taboo topic and when I’ve seen families be secretive about money, it sometimes leads to strange family dynamics, a terrible relationship with money, and an inability to handle finances later in life. 

I’m not advocating for telling your five year old grandchild you have $20,000 saved for them, but I do believe you can approach money and get them involved differently as they age. 

For example, maybe when they are young, you use part of an investment to make a charitable contribution and have them pick the charity. You can explain how the earnings in the account grew, and it’s good to give back.

Maybe when they are 10, you can have them pick an individual stock they like and invest into it within a custodial brokerage or custodial Roth IRA account. 

As they grow older, you could have them read a book or a website about investing and have them make a plan for investing 25% of an account while you control the other 75%. Over time, perhaps those percentages can change to give them more control. 

Each grandchild is different, which means the approach needs to be different. In general, I’ve found individual stock picking when they are younger is helpful, but as they age, bringing them around to the idea of diversification and boring investing is important. 

Something else I’ve seen be successful is offering matching funds. You could promise to match any retirement or custodial brokerage deposits they make with an equal amount from you. For example, if they save $1,000 to a custodial Roth IRA, but they had at least $2,000 in earnings, you could match the $1,000. If they didn’t have enough in earnings, you could match it towards a 529 plan or custodial brokerage account. 

How Much to Give

Ah, yes. The question that will likely live until the end of civilization. How much do I give my grandchild? 

If you give too much, they might be spoiled and have an incentive not to work as hard. If you don’t give enough, they might be at a disadvantage to others. 

It’s a difficult balance. 

Something I’ve found interesting over the years is that grandparents who are now wealthy, but were not wealthy growing up, want to give as much as possible, but also tell me how part of their success is due to not having resources and that provided motivation to work harder to gain wealth. 

I’m not sure what you can do with that information, but I think it’s worth pointing out that what people partially attribute to their success, they sometimes deny others. 

Whether you want to use your annual gift tax exclusion or superfund a 529 plan, you have plenty of options to give thousands or tens of thousands of dollars per year. 

Something to keep in mind is when your grandchild gains access to the money. If you do a phenomenal job saving money into a custodial Roth IRA and it’s worth $50,000 when they turn age 18, they can technically do whatever they want with that account when they receive it. 

I often see families do a little saving to a few different types of accounts to limit the amount of access a grandchild gets at age 18 or 21. Usually, I see larger balances in the 529 plan, followed by a custodial brokerage, and then the custodial Roth IRA. 

How I Would Invest if I Had Grandchildren

I don’t have grandchildren, but if I did and had more than enough for my lifetime, this is what I would do.

I would fully fund their custodial Roth IRA as early as I could with as much as I could. Time is one of the greater opportunities young people have for compounding. 

Even if that account is worth more than most people want an 18 year old to have, I would be willing to take that risk. Of course, there is always the exception that if my grandchild was displaying habits that were not in line with being able to handle money well, I could stop or pause the contributions. 

Along the way, I’d do my best to teach them about investing, get them involved, start making decisions about the account, give them view only access, and move from individual stocks to boring ETFs for the majority of the account as they age. 

Next, I’d fund 529 plans for my grandchild to a 50% or a 75% level. Again, this is assuming I have more than I need. For example, if school was going to cost $200,000 over four years, I’d aim to have $100,000 to $150,000 in a 529 plan. 

I don’t aim for 100% funding because you never know what sort of scholarships a grandchild may get or how expensive a school they decide to attend. There is also less flexibility with a 529 plan, unless you have many other grandchildren within the same family you can move the funds to. 

This would be 100% boring money. It would be ETFs or mutual funds tracking an index. 

Finally, I’d set aside some money in a custodial brokerage account. I’m not providing an amount because this is where I’d need to tailor it to the grandchild. I could only get so much money into a Roth IRA before they turn 18. It’s usually not enough to totally wreck someone’s life if they gain access and blow it all in a day. 

I’ve seen custodial brokerage accounts balances large enough where when they are turned over, they could destroy someone’s life if the grandchild is not in a space to manage the account responsibly. 

This is another account where I’d attempt to get the grandchild involved, research individual stocks, and move to a more ETF-focused account as they get older, but give them a part of the portfolio they could continue investing in individual stocks, such as 10%. 

Please keep in mind that personal finance has the word personal in front of it for a reason. Each family is different. Everyone has different values. This is what I would do, but this may not work for you. 

Plus, if I had grandchildren, I may change my mind entirely! You never know until you go through it and only in hindsight might you know what would have been best. 

Final Thoughts – My Question for You

Gifting and investing for your grandchild is a wonderful act of kindness. 

Whether you use a 529 plan, custodial Roth IRA, custodial brokerage, TreasuryDirect, or Coverdell Education Savings Account, they each offer their own advantages and disadvantages. Some provide more flexibility, such as custodial brokerage, while others provide more tax advantages, such as a 529 plan. 

The other key decision to make is what types of investments you are going to use. Some of this depends on the time frame for using the funds, while another piece of the puzzle is how you want to engage your grandchild. It’s even more challenging because the type of investment may need to change over time to teach good investing habits. 

Whether you give $1 or $1,000,000+, having a plan about how you are going to give, how much you plan to give, and what types of investments you are going to use is important. 

I’ll leave you with one question to act on. 

When will you create a giving plan for your grandchildren? 

ElliottAppelAbout the Author
Elliott Appel, CFP®, CLU®, RLP®, is a Financial Planner and Founder of Kindness Financial Planning, LLC, a fee-only financial planning firm located in Madison, WI that works virtually with people across the country. Kindness Financial Planning is focused on helping widows, caregivers, and people affected by major health events organize and simplify their financial lives, do proactive tax planning, and make sure insurance and estate planning is coordinated with smart investment advice.

 

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