Stocks for kids

My niece is turning three this month so I've been spending some time figuring out what to get her. I came up with three options: toys, activities, and stocks. She has plenty of toys already so when I looked through the aisles at some local toy stores, nothing jumped out at me. Does she need yet another doll? I decided not. Activities are a nice gift but she's already enrolled in gymnastics and my mom is getting her swimming lessons. That left me with stocks. I've been wanting to do that for a few years, to be honest, but now I'm finally doing some research into how it's done.

The thing is, what's the best way to give stocks to other people's kids? I guess for most people the easiest way is to give the parents the money and ask them invest it. I sort of tried that already with my other niece (both are my sister's daughters) but my sister said something pretty shocking: She told me she was going to take all the birthday money from everyone and put it towards a sandbox! Maybe that's not shocking, I don't know. I was shocked but my mom thought it was fine.

My sister's in-laws actually avoided the situation by announcing that they had opened a savings accounts for each child and deposited some money into them. At the time (this was before my sister's plan was revealed) I thought, wow isn't that kind of rude and mistrustful? Plus, how wise is it to save $X.00 a year in a SAVINGS ACCOUNT earning 2% interest or whatever, when the money won't be needed for perhaps 20 years?

Anyway, when my sister let slip her intentions for all the money, I realized the importance of being able to maintain some control over your gift. Not to be mean, but I want to give this gift to my niece and not my sister. I'm sad that she doesn't already have a nice little stock trading account with a few years' worth of investments.

So I began investigating what options I had.

The easiest thing is for parents to be involved, no question. Everything I read pretty much assumes that the parents are the ones setting up the account, whether it's an IRA, 529 account, or custodial account.

It turns out that for 3-year olds, IRAs are pretty much out of the question. Apparently the IRS doesn't consider allowances to qualify as earned income, and nobody would believe a 3-year old was a participant in a home business. Then I read that you can actually deposit unearned income in an IRA and pay a 6% penalty on it. Not bad, right? A 6% penalty in exchange for tax free growth! Well then I found out that the 6% penalty happens every year that the unearned income remains in the account, until it's all gone! So IRAs are definitely out.

Section 529 plans are almost an ideal solution to the issue. Anybody can open one and you don't even have to be related to the beneficiary. There are two reasons I don't like them, though. First of all, they're limited to paying for education-related expenses (college). What if she gets a full scholarship and doesn't need the money for college? Then you pay income tax on the withdrawal plus a 10% penalty. Well, paying for college is a really boring gift that is better left to her parents anyway. I'm thinking she can use it to buy a car, start investing, or travel around Europe!

Oh and the second reason is that they are awfully limited in their investment choices. The 529 plan for my state doesn't offer the ability to buy individual stocks. Instead, you have to choose from 12 mutual funds. That's not my style.

Coverdell ESAs (Education Savings Accounts) are similar to 529 plans except that (from what I can tell) only the parents can set one up (though anybody can contribute) and you can invest in stocks. Again, there's a penalty if the child uses the money for non-educational expenses, plus there's the whole thing about the parents having to set it up.

Custodial accounts are generally (always?) opened by a parent of the child. The bad thing about them is that anything you put into the account actually belongs to the child. When they turn 18, they can do whatever they want with it. To me, the ideal time for a gift like this is a year or two after college graduation. That way they have some life experience and some appreciation for money and savings.

Then I read three very interesting things. First, the gift tax exemption is something like $12000 a year, and if you're married you can use both exemptions for a total of $24000. Second, if you transfer shares of stock to someone as a gift, the characteristics such as basis cost and time held stay the same. Third, if you're in a low tax bracket (10% or 15%), the long-term capital gains tax is only 5%! Whoa! So basically, by keeping the stocks myself, I can give her up to $12000 in stock per year and if she sells immediately she only has to pay 5% capital gains tax. Good deal! Of course, I'll have two responsibilities in the meantime: pay taxes on dividends (which won't be huge) and make sure to buy-and-hold (no problem). Plus I have to make sure to give it all to her before she starts making lots of money.

So yesterday I opened up a new Sharebuilder account in my name and used a promotion code to get a $50 gift. Plus, I signed up for a free trial of their "standard pricing" program, which means I get 6 free trades. So I'm taking the promotion gift and the birthday gift and investing in a single stock. I'm thinking about doing the Christmas gift now too, to avoid commissions.

I'm plagued with doubts about whether I did the right thing, though. Is it mean to basically prevent my sister from using the cash as she sees fit? Do I have to get my niece a regular present as well, since a Sharebuilder account statement isn't very exciting? Have I overlooked any important tax consequences of this action?