Time is the most powerful asset an investor possesses, and children have more of it than anyone else. When you start investing for a child, you aren’t just saving money; you are leveraging decades of compound interest that can turn modest contributions into substantial wealth.
However, deciding where to put that money can be paralyzing. Two of the most popular vehicles for building wealth for minors are the Custodial Roth IRA and the Uniform Gifts to Minors Act (UGMA) account. Both offer distinct advantages, but they serve different purposes and come with vastly different rules regarding taxes, eligibility, and access.
Choosing the wrong account could result in unexpected tax bills, a loss of financial aid eligibility for college, or handing over a large sum of money to an 18-year-old who isn’t ready to manage it. To make the best choice for your family’s financial future, you must understand the mechanics, benefits, and limitations of each option.
Understanding the Custodial Roth IRA
A Custodial Roth IRA is a retirement account managed by an adult for the benefit of a minor. It functions almost exactly like a standard Roth IRA for adults, but with a few logistical tweaks to accommodate the account holder’s age.
The Golden Rule: Earned Income
The most critical requirement for a Custodial Roth IRA is that the child must have earned income. This is non-negotiable. You cannot open a Roth IRA for a newborn or a toddler unless they are working as a paid model or actor.
Earned income includes wages, salaries, tips, and other taxable employee pay. It also includes self-employment income from “gigs” like babysitting, mowing lawns, or dog walking, provided you keep accurate records. It does not include allowance, birthday money, or investment income.
Contribution Limits
You can contribute up to the annual limit set by the IRS ($7,000 for 2024) or the total amount of the child’s earned income, whichever is lower.
For example, if your teenager earns $2,500 over the summer working as a lifeguard, the maximum amount that can be contributed to their Custodial Roth IRA is $2,500. You (the parent) can be the one to fund the account, effectively acting as a “match” for their earnings, but the total contribution cannot exceed what the child actually earned on paper.
Pros of the Custodial Roth IRA
- Tax-Free Growth: This is the headline benefit. Because contributions are made with after-tax dollars, the investments grow tax-free. If the rules are followed, withdrawals in retirement are also tax-free. Given that a child has 40 to 50 years for that money to grow, the tax savings can be astronomical.
- Flexibility for Education and Housing: While it is a retirement account, the IRS allows penalty-free withdrawals for qualified higher education expenses. Additionally, up to $10,000 of investment earnings can be withdrawn penalty-free for a first-time home purchase (after the account has been open for five years).
- Principal Access: Contributions (the money you put in, not the earnings) can be withdrawn at any time, for any reason, without penalty or tax. This acts as a safety net in emergencies.
- Financial Aid Friendly: Retirement accounts are generally not considered assets on the Free Application for Federal Student Aid (FAFSA). Money in a Roth IRA typically won’t reduce a student’s eligibility for financial aid.
Cons of the Custodial Roth IRA
- Strict Eligibility: If your child doesn’t have a job, this option is off the table.
- Contribution Caps: You are limited by the earned income ceiling. You cannot drop a lump sum of $10,000 into the account if the child only earned $500.
- Withdrawal Restrictions: While you can access the principal, accessing the earnings before age 59½ usually triggers taxes and a 10% penalty, unless an exception applies.
Understanding the UGMA Account
The Uniform Gifts to Minors Act (UGMA) account is a type of custodial brokerage account. It is essentially a standard taxable investment account used to hold financial assets for a minor until they reach the age of majority.
How it Works
Unlike the Roth IRA, there is no earned income requirement. Parents, grandparents, or friends can contribute to a UGMA at any time. The account is managed by a custodian (usually the parent) until the child reaches adulthood—typically age 18 or 21, depending on the state. At that point, the custodianship terminates, and the beneficiary gains full, unrestricted control of the assets.
Pros of the UGMA Account
- Universal Eligibility: Anyone can open a UGMA for any child. It is an excellent option for newborns or young children who are years away from their first paycheck.
- No Contribution Limits: There is no IRS cap on how much you can put into a UGMA. However, you should be mindful of the federal gift tax exclusion ($18,000 per donor per year in 2024) to avoid filing extra paperwork.
- Spending Flexibility: The money in a UGMA can be used for anything that benefits the child, as long as it isn’t a parental obligation (like basic food, shelter, and clothing). You can use the funds for summer camps, braces, a laptop, private school tuition, or a car.
- Wide Investment Options: You can invest in stocks, bonds, mutual funds, and ETFs, much like in an IRA.
Cons of the UGMA Account
- The “Kiddie Tax”: Investment earnings in a UGMA are taxable. A certain amount of unearned income (dividends, interest, capital gains) is tax-free, and the next bracket is taxed at the child’s (usually lower) rate. However, earnings above a specific threshold ($2,600 in 2024) are taxed at the parents’ marginal tax rate. This can diminish returns compared to a tax-sheltered account.
- Financial Aid Impact: This is a major drawback for college planning. UGMA accounts are considered an asset of the student. On the FAFSA, student assets are assessed at a rate of 20%, meaning every $1,000 in a UGMA could reduce financial aid eligibility by $200.
- Loss of Control: Contributions to a UGMA are irrevocable gifts. Once the money is in the account, it belongs to the child. When they reach the age of majority, they can use the money for whatever they want—college tuition, a down payment on a house, or a luxury sports car. You cannot legally prevent them from spending it foolishly.
Head-to-Head: Taxes, Financial Aid, and Control
To make the best decision, it helps to look at how these accounts compare across three major pillars of financial planning.
1. Taxation
The Custodial Roth IRA is the clear winner for tax efficiency. You pay taxes on the money before it goes in, but you never pay taxes on the growth or qualified distributions again. This creates a powerful shield against future tax liability.
The UGMA offers limited tax benefits. While the first portion of earnings is tax-free or taxed at a low rate, significant growth will eventually trigger capital gains taxes. If the account grows substantially, the “Kiddie Tax” can result in a tax bill similar to what you would pay if the money were in your own brokerage account.
2. Financial Aid Eligibility
If college financial aid is a priority, the Roth IRA is superior. Because retirement assets are excluded from the FAFSA calculation, a Roth IRA allows you to build wealth for your child without penalizing their chances of receiving need-based grants or loans.
The UGMA is one of the least efficient vehicles for college planning from a financial aid perspective. Because the assets technically belong to the child, financial aid formulas expect a significant portion of that money to be used for tuition, drastically lowering the aid package the family might receive.
3. Control and Transfer of Assets
This category often drives the final decision for many parents.
With a UGMA, the transfer of assets is automatic and absolute. If your state’s age of majority is 18, the child gets full access on their 18th birthday. For parents worried about their child’s financial maturity, this “cliff” can be concerning.
A Custodial Roth IRA offers slightly more nuanced control. While the account technically belongs to the child, the rules regarding withdrawals act as a natural barrier. Since there are penalties for withdrawing earnings before retirement age, the child is incentivized to leave the money alone. Furthermore, custodian control usually lasts until age 18 or 21, similar to a UGMA, but the “retirement” label psychologically frames the money as long-term savings rather than spending cash.
Making the Choice: Scenarios
Choosing between a Custodial Roth IRA and a UGMA often comes down to the child’s age and income status.
Scenario A: The Newborn or Toddler
If the child is very young, the Custodial Roth IRA is likely impossible because they do not have earned income. In this case, a UGMA is a viable option if you want to gift stock or cash for general future use. However, if the specific goal is education, a 529 College Savings Plan might be a better alternative to a UGMA due to its tax benefits.
Scenario B: The Working Teenager
Once the child has a part-time job, the Custodial Roth IRA becomes the gold standard. The tax-free growth potential outweighs the benefits of a UGMA for most families. Even if the teen spends their paycheck, a parent can fund the Roth IRA up to the amount the teen earned, effectively transferring wealth into a tax-free shelter.
Scenario C: High Net Worth Estate Planning
For families looking to move assets out of their estate to lower future estate taxes, the UGMA (and its sibling, the UTMA) allows for larger transfers of wealth without the contribution limits of an IRA. This is useful for grandparents who want to pass down significant assets early, provided they are comfortable with the tax implications and the child receiving the funds at adulthood.
The Hybrid Approach
You do not necessarily have to choose just one. Many families utilize both accounts to achieve different goals.
You might open a UGMA when the child is born to hold birthday checks and gifts. This money can serve as a mid-term fund for a first car, a gap year, or wedding expenses. Later, when the child gets their first summer job, you can open a Custodial Roth IRA to begin their long-term retirement compounding.
By using the UGMA for medium-term liquidity and the Roth IRA for long-term wealth building, you cover all bases.
Securing Their Financial Future
Whether you choose the tax-advantaged power of the Custodial Roth IRA or the flexibility of the UGMA, the most important step is simply starting. The magic of investing for children lies in the time horizon. A small sum invested today has decades to weather market volatility and accrue interest.
If your child has earned income, prioritizing the Roth IRA is usually the smartest financial move due to the tax benefits and financial aid protection. If they are too young to work, a UGMA is a solid tool to teach them about the stock market, provided you understand the tax and financial aid trade-offs.
Assess your child’s eligibility, your goals for the money, and your comfort level with handing over control. By matching the right account to your objectives, you are giving the next generation a profound head start.
