Investing for a Child

My son is 14 months old, and I would like to place a one-timelump sum amount ($2,000 to $4,000) in either mutual funds or a Roth IRA. I understand that the account will become his once he hits 18, but I would hope that the money could continue growing until he turns 65. What issues do I need to be aware of and whichinvestment vehicle is preferred?

What a great idea. However, you can't open a Roth IRA for him until he has earned income himself, so you'll need to wait several years until his first job. But you do have other options until then.

If you want the best tax benefits, start contributing to a 529 college-savings plan now, where the money can be used tax-free for college. You may even get a state income-tax deduction for your contribution. See Find the Best 529 Plan for details about each state's plan and a list of our favorites.

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The downside to the 529, though, is that he must use the money for college (or grad school) or else pay a penalty (see Avoid 529 Penalties for details). If you want to start building savings in his name that he can hold onto for the rest of his life, the best option you have now is with a custodial account.

With a custodial account, you can invest the money however you want now and use it for his benefit until he reaches the age of majority (18 or 21, depending on the state), when he will control it. You won't have the tax advantages that you'd have with a 529 or a Roth. And the tax laws recently changed so that custodial account dividends and capital gains above a certain amount are now taxed at the parents' rate, rather than the child's lower rate, until the child turns age 18 (and in 2008, the age rises to 19 for dependents or 24 for dependents who are full-time students). For more information about the new rules, see Congress Closes the Kiddie-Tax Loophole.

To get the maximum tax advantages from this very long-term savings, I'd recommend investing some money in a 529 now to save for college, then opening up a Roth IRA for your son as soon as he has any earned income -- even if it's just from mowing lawns or delivering newspapers.

Even though he can't invest in the Roth quite yet, it really does offer the best tax benefits for his future and can give him a tremendous head start on his retirement savings. He'll be able to withdraw the contributions tax- and penalty-free at any age and can take out the earnings tax-free after age 59½, as long as he's had a Roth for at least five years.

His contribution amount will be limited to his earned income for the year. So he may only be able to contribute $1,000 in the first year, for example, if that's how much he earned from his job. But he doesn't have to contribute the money himself; you can give him the cash to open the account, as long as it's no more than his earned income.

That small start can make a huge difference over time, especially if he waits 50 years before touching the money. If you give your son $1,000 to fund a Roth IRA when he's 15 years old and the money inside the account grows at an annual average rate of 8% -- well below the long-term average return for stocks -- then that $1,000 will grow to about $47,000 by the time he's 65. That's just from the original $1,000 investment. If you added another $1,000 a year until he turned 20, then that initial $5,000 investment would be worth nearly $250,000 by his 65th birthday -- even if he never added another dime.

See Why Your Kids Need a Roth IRA for more information, and see Roth Rules for Kids for details about which jobs count (it has to be a real job, not just allowance for chores around the house) and how to find an IRA administrator that will let you open an account for a minor. And check out Ride a Roth to Riches for advice about getting started and investing the money.