A Head Start on the Road to Riches

By Amy Esbenshade Hebert

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Maya's parents, Cameron and Alex, of Bowling Green, Ky., are adding money regularly as they start to teach their daughter to save. "Right now, it's a bit of a game to her," says Cameron, because Maya would rather play with the change and grab for bills she sees peeking from Mom's wallet.

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But cash in the piggy bank will eventually reside in an interest-bearing account, and as both Maya and her balance grow, the game will turn into an education.

Teaching your children to save is one of the best gifts you can give them. But you may also want to pass on a more material legacy. To save for college, state-sponsored 529 plans are hard to beat.

As a parent or grandparent, you may have other savings goals for the kids in your life -- a down payment for a first house, money to pay off college loans, a head start on retirement or just-for-fun money. Or you may want to move assets out of your own taxable estate. Whatever your goals, you have a number of ways to give kids a push toward becoming a millionaire . . .

Open a custodial account.

The quick-and-easy way to give children money, stock or other assets is through a custodial account. (Minor children also have to open a custodial account in order to save or invest their own money.)

Depending on the law in your state, custodial accounts go by the name of UGMA (Uniform Gifts to Minors Act) or UTMA (Uniform Transfers to Minors Act). It's simple to set up an account and name a custodian -- often yourself -- to manage it while your child is still a minor.

Assets in the account belong to your child, but the custodian can distribute them for the child's "use and benefit." That could include summer camp or private-school tuition, but not a parent's legal support obligations.

Drawbacks. Convenient as they are, custodial accounts have a number of drawbacks. For one, the gift is irrevocable. Once you give money to a child, you can't get it back, nor can you transfer it to a sibling. Also, custodial accounts are considered a child's asset in college financial-aid calculations, so they're assessed more heavily than parental assets.

Another problem: Kids get control of their money once they reach the age of majority in their state -- generally at 21. So be prepared to live with the result -- which may be red, shiny and parked in your driveway.

Tax considerations. And then there's the tax issue. The IRS used to look favorably upon custodial accounts; earnings in the accounts were typically taxed at a child's lower rate. Not anymore. In 2008, the first $900 of a child's investment income is tax-free, and the next $900 is taxed at the child's rate. After that, however, dependents younger than age 19, as well as dependent full-time students younger than 24, are subject to the so-called "kiddie tax" -- meaning that unearned income in excess of $1,800 is taxed at their parents' higher rate.

As a result of the tax changes, custodial accounts are best for small sums of money or appreciating assets your child won't need to sell until he or she is beyond the reach of the kiddie tax. Assuming 5% earnings, for instance, your child's account would have to exceed $36,000 before triggering this year's tax.

If you're worried about control of the account, bear in mind that if the donor, the custodian or the child live in different states, you may open the account in whichever state has the strictest provisions.

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Start a Roth IRA.

If your children have earnings from a job, open a Roth IRA on their behalf -- even if you are making other investments for them, too. "I would say unequivocally that a Roth is the way to go," says Barbara Camaglia, a financial planner in Beachwood, Ohio. "Young people have plenty of time to benefit from compounding, and earnings in the account will be tax-free in retirement."

Alan Weiner of Needham, Mass., couldn't agree more. His children, Katie, 14, and Daniel, 13, opened Roth accounts last year at Charles Schwab with a few hundred dollars each. Katie gets paid for baby-sitting, and Daniel earns money by doing yardwork for family members and neighbors and by occasionally sitting with his grandmother, who suffers from Alzheimer's disease.

Like adults, in 2008 kids can make a Roth contribution of up to $5,000 or 100% of their earned income, whichever is less. Weiner and his wife, Annette, used their own money to fund their children's accounts up to the amount of the kids' earnings. That's fine with the IRS as long as the contributions don't exceed your child's actual earned income.

In the future, the Weiners plan to have the kids fund their accounts on their own. And they'll continue to explain finances to Katie and Daniel. "We want them to handle money better than we have," says Alan. "We were almost 40 when we started saving for retirement."

Finding a place to open a Roth IRA for your child should be a snap. In addition to Schwab, brokerage firms E*Trade, Muriel Siebert, Scottrade and TD Ameritrade welcome IRAs for kids, as do mutual fund families American Century, T. Rowe Price and Vanguard. Also on the list: Bank of America, Citibank and PNC. One notable exception is Fidelity, which does not open IRAs for minors.

Minimum investments vary. Schwab will open a kid's IRA with as little as $100; TD Ameritrade and Siebert have no minimums. At American Century and Vanguard, the minimum is the same as the fund's minimum investment.

Ask whether there are additional fees. T. Rowe Price, for example, charges $10 a year for balances less than $5,000.

Where to invest. If you or your child is starting with a small amount of money, you want to keep transaction costs and investment requirements low. More than 1,000 major companies, including Coca-Cola (symbol KO) and Walt Disney (DIS), allow you to bypass broker commissions and buy stocks directly.

But for most stock purchases, you'll need a broker. A good choice for shoestring investors is a no-frills discount broker, such as ShareBuilder (www.share builder.com), which has no minimum investment, no account minimum and no inactivity fee. It costs just $4 to buy a stock (or $12 a month for unlimited purchases). You can even buy fractional shares if you want to invest a fixed amount each month.

Among mutual funds with low minimum investments, Kiplinger's favorites include Homestead Value ($500 minimum), which looks for U.S. companies that are undervalued; Hodges fund ($250 minimum), run by a father-and-son team that focuses on companies of all sizes with increasing profits; and Pax World Balanced ($250 minimum), a socially screened fund that doesn't buy companies that earn significant revenues from alcohol, gambling or weapons. (More on Kiplinger's Favorite Funds)

Investors who open a Charles Schwab account for $1,000 need only $100 to invest in any of the company's funds. A good bet is Schwab Core Equity, which uses computers to select large-company stocks based on a number of factors.

Other ways to save. To maintain maximum flexibility and control, you could open a separate taxable account in your name and earmark it for your child. To minimize taxes, save in a growth-stock mutual fund that generates capital gains but few dividends, then wait to transfer assets until your child is free of the kiddie tax.

And for tax-planning purposes, you can take advantage of losses in a taxable account. "I'm not saying you shouldn't save in other ways as well, but you want to build in as much flexibility as possible," says Phil Watson, a financial planner in Franklin, Tenn.

What about that old standby, the U.S. savings bond? Right now you can earn a significantly higher interest rate with an online savings account or high-yield certificate of deposit (scroll down this page to see latest rates). Still, savings bonds "make an excellent teaching tool," says Watson.

MORE: Track Janet Bodnar's Advice to Raise Money-Smart Kids