Trust Funds

This site has two main themes – the trust funds that I am setting up for my nieces and nephews, and general posts on investing. As always with any investment, DO YOUR OWN RESEARCH!

My Trust Fund Plan – Matching Stock Investments

I have eight nieces and nephews and no kids of my own on the horizon.  As a result, I decided to set up a trust fund for each of them from the time they get to be 10 years of age until they are at least 18, probably I will continue until they are finished with college. ( In Illinois, the age of consent for UGMA is 21 years old – this is unique for each state – at this point the custodianship ends and the funds transfer directly) I will fund this as follows:

  • Contribute $500 / year
  • Match any contributions that they make up to another $500 / year

The purpose of setting up this trust fund is to 1) teach kids about how stock markets and investing works 2) provide them with an incentive to save money (through the match of their contributions) 3) allow them to invest without a significant risk of loss of their contributions (the fund may lose money on stocks, but since up to 2/3 of the total amount represents my contributions, the losses would have to be very large before it impacted their portion of the contributions).

The results so far have been better than expected.  The “match” concept was well received, and each nephew & niece did save up the entire amount of the match every year.  Our picks have “beaten the market” over that time span, but unfortunately the benchmark is negative.  It is difficult to explain relative performance to an adult, let alone a minor.

Each nephew or niece is truly the one selecting the stocks (2 stocks from a list of 6), so they have ownership in the outcome.  For one nephew (portfolio one), this is the fifteenth cycle of investing (2001 – 2015) and for the second portfolio this is the eleventh year of investing (2004 – 2015).  Portfolio Three has been open from in 2007-15 and started investing in a tough market (the 2008 “crash”). Two more portfolios (four and five) began in 2009 and have five years under their belt.  A sixth portfolio just began in 2012.  The last two near-term portfolios, seven and eight, both began in 2015.

Setting Up A Trust Account

It is easy to set up a trust account with any of the major financial management firms (Vanguard, Fidelity, etc…).  You can create an account where you are the trustee and you can control the buy / sell activity, but both you and the beneficiary can view the activity and results online.  This is a good type of setup since they can see the activity but can’t change the outcome (after all, you are the trustee).  To see the Vanguard site area, go to their home page and then type in “UGMA” and hit search.

If you set up their trust funds under your brokerage “umbrella” (they are separate accounts and the assets are held in the name of the trustee) costs seem to be low and getting lower. Commissions have come down significantly from the $25 or so a trade (buy or sell) that they started at when I began this effort in 2002. The fund providers also don’t seem to be charging account maintenance fees the same way that they used to. Each provider is unique so look into the details. These sorts of costs add up.  Currently I am able to use available free trades on my own account so that for the last year or so the trades made in the trust fund accounts are commission free, which also helps given that $50 (2 buys at $25 / each) used to be a significant portion of a $1500 annual investment every year (about 3% of the total).  I am certain that if you look around the internet you can get lower than $25 / trade, if you are starting from scratch.

The type of account is a UTMA (in Illinois) and the official definition is:

“UNIFORM GIFTS / TRANSFERS TO MINORS ACT (UGMA / UTMA) in ILLINOIS – Irrevocable account established for the benefit of a minor but administered by a custodian.  The initial investment is provided by the custodian as a gift or transfer of assets.”

Taxes

Under this account, any gains / losses on the sales of stock are taxable for the child.  They are also taxed on the interest received (which is nominal) as well as the dividends received on each stock.  The general intention of these funds is not to do a lot of trading, but we do monitor the stocks and we do trade 1) stocks that perform poorly over an extended period of time and don’t seem to have a good chance of turning around 2) winners that seem to be moving to a level that is unsustainable.

The level of income passed to the child generally isn’t that high but they will have to pay taxes during years when there are a lot of sales of “winners”.  Their tax rate is low by themselves but at some point it becomes taxable at the parents’ rate.  As the child begins to earn money on their own (i.e. around age 16 when they get a formal summer job) then the amount of income subject to taxation is effectively higher because their “base” income goes up, as well.  While the tax issue isn’t a deal-breaker, it is a pain, but you should make investing decision based on the economics of the stock and not put off decisions based on taxes.  Originally I was moving for more of a “buy and hold” model but due to the rising and falling of some of the elements of the portfolio I had to move into a more active model to achieve better results.  In years when I sell stocks that have losses I also look to sell appreciated stock to “step up” the net basis of the portfolio if possible (as long as that isn’t bad for investing, meaning it is time to sell the stock anyways).

In the past, assets held in a child’s name such as a custodial account (UGMA or UTMA) received favorable tax treatment.  The income earned by the fund was taxed at the child’s rate, which is often far below the parent’s rates (because children generally don’t have a salary nor earn much money).  Under a 2005 tax ruling, now children 18 and under are subject to the “Kiddie Tax” which requires that their earnings be taxed at the parent’s rates.  Children who don’t earn a salary have an exemption of the first $850 of income and then the next $850 of income is taxed at 10%.  After this $1700 of income, the tax is computed at the parents’ rate.  Due to the fact that capital gains and dividend income are treated more favorably than interest income in the tax code (they have a lower effective rate) these types of assets are better for the child’s account.  At the IRS site you can download “FORM 8615 TAX FOR CHILDREN UNDER AGE 18 WITH INVESTMENT INCOME OF MORE THAN $1700″.  If you are a tax expert or CPA you can go to the July 2007 Journal of Accountancy where they have an article titled “The Dreaded Kiddie Tax“.  You may also want to just add the child’s income to the parents’ return directly to save the hassle; there is a separate form for this, as well (FORM 8814 PARENT’S ELECTION TO REPORT CHILD’S INTEREST AND DIVIDENDS).  I recommend downloading IRS “PUBLICATION 929 TAX RULES FOR CHILDREN AND DEPENDENTS” for additional assistance (note that this document is relatively incomprehensible…).  As the children start to earn income (if they get a job when they turn 16, for example) they will have to file if they receive more than $300 in “unearned” income.  For this purpose unearned income is interest income (from bonds, for example), dividend income (from stocks) or capital gains (proceeds from sale of stock, net of any losses).

I learned more about trust funds at a site named Fairmark, where they have tax publications.  I posted some questions on the message board and received a fast reply that seemed to answer my question.  Once again, you can’t just rely on information you receive on a message board, but it often points you in the right direction and you can verify the opinion against an official tax publication or other more definitive source.

Why Individual Stocks and Not Mutual Funds or ETF’s?

My goal with this purpose is not as much to help each of them save for college but to teach them about investing and hope that by the time I stop contributing to this they have built up habits where they can continue to save and invest on their own.  That is the reason that I am selecting individual stocks instead of mutual funds (or ETF’s, which were rare or nonexistent when this match concept began in 2001 but are the majority today).  In general, stocks are more expensive in terms of commission and there is not much diversity in a portfolio of just a few individual stock issues.  If this was someone’s portfolio strategy on a large scale, it would be a high risk plan.  However, if you are a kid talking about mutual funds is BORING but talking about individual companies and why they make good (or bad) investments is much more INTERESTING.  The funds have been achieving this result, so far.

UGMA / UTMA vs. 529 Account or Other Investing Options

The tax treatment for UGMA or UTMA accounts is less favorable than the 529 accounts.  You aren’t taxed on the money that you put IN to the UGMA account (because it was already included in your income) but you ARE taxed on the interest income, dividend income, and capital gains that the money earns.  Tax is calculated every year and you need to file when it crosses the above thresholds.  For a 529 account, on the other hand, if you put money in, it grows tax free, and if you use the proceeds for college, you will never pay taxes on the gains earned by the money from the time it was deposited into the account.

Even with the tax trouble the UGMA may still be a decent investment vehicle because it gives you total control over your choices and the money isn’t as abstract as putting it into a 529 account, which generally only limit you to a relatively small universe of mutual funds.  This sort of “match” plan is more difficult to implement in a 529 plan and you can’t customize the portfolio, as well as paying higher fees (Illinois used to have very high expenses for their “Bright Star” plan but they switched over to Vanguard and now their expenses are among the lowest of the 50 states).  For the vast majority of people I’d recommend a 529 over a UGMA account; but for my own particular situation a UGMA is better because the assets will go to the child whether or not they go to college and they can participate in the asset growth and learn about investing at a measured pace.

UGMA / UTMA vs. 529 For Financial Aid:

A 529 plan is also superior for financial aid.  Assets in a 529 plan do not count against a child when they apply for financial aid, while UGMA / UTMA assets do.   In normal circumstances I would recommend a 529 plan for the “primary” funding for a child’s education, and not a UGMA / UTMA.

The Trust Issue:

While I will concede that there are legitimate objections to individual stocks vs. mutual funds / ETF’s (risk of diversification, lack of ability to beat the market in the long run) and UGMA / UTMA vs. 529 plans (tax inefficiences, the fact that 529 plans do not count against financial aid limits) I do not accept the “trust” argument that I frequently hear, which comes down to:

“How do you know that the child won’t just waste the money once they come of age and have full control?”

In a nutshell, you don’t know that this won’t happen.  But if you work with someone and they have an investment stake in the money included in the fund, it seems unlikely that a child who is now an adult that you worked with for years would all the sudden become totally irresponsible and just “blow” the money.  It COULD happen, but why would you plan for that?  Is this how much faith that you have in your child?  Remember, they didn’t just receive this money, they contributed to the investment, and had a significant stake in directing the outcome of the investments.  I really think it is wise to hope for the best.

Topics In This Blog:

Topics covered in this blog will include:

  1. Basics of stock markets
  2. Working with your brokerage account
  3. Factors to look for in selecting investments
  4. Impact of taxation
  5. Stocks we are including in our portfolio (remember – DO YOUR OWN RESEARCH)
  6. Other general financial advice

Others may “join” this site in the future… I have a lot of friends in the investment world and they may also want to help educate others.  I finally got a friend to join me, Dan From Madison, and it really has livened the place up a lot.

3 thoughts on “Trust Funds”

  1. My apologies for posting this here, but I wanted to thank you for the certification help site. I know you haven’t been updating it lately, but it’s been a tremendous help to me during my current CPIM pursuit.

    Hope this finds you and thanks again.

    C.

    Like

  2. Thank you very much for the kind words and glad you like the CPIM site. It is true that I haven’t been updating it much any more but I am leaving it out there because it doesn’t cost me much in terms of hosting and I was hoping someone would enjoy it.

    Like

  3. Thank you for the information here. I was researching ways in which one can invest for a minor. I like this trust idea, and will look further into it.

    Like

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