The Best Ways to Give a Financial Gift to Children

By Christine Benz, Morningstar

Wealthy individuals often go to great lengths to pass assets to their heirs, setting up trusts and using other elaborate mechanisms to ensure an efficient transfer of assets. But don't think you need to be a Rockefeller to have a meaningful impact on the financial futures of your children and grandchildren. You can fund various types of financial accounts with as little as $25 to start.

Here are some of the key strategies to consider when giving children and grandchildren a financial boost. There's no one-size-fits-all answer: The right choice for your situation will depend on how much you intend to give as well as your grandchild's life stage and the goal of financial assistance.

Strategy: Set up a UGMA/UTMA account.

Best for: General savings and investing, particularly for relatively small dollar amounts.

Overview: UGMA/UTMA accounts provide a way to save on behalf of a minor child without setting up trust funds or hiring attorneys. As a donor, you'd appoint yourself or other adults (such as the child's parents) to look after the account. One of the key advantages with UGMA/UTMA accounts is flexibility: You can put a huge range of investment options inside a UGMA/UTMA wrapper, including stocks and mutual funds.

If you're saving fairly small sums, these accounts can be a decent way to go, but there are two major hitches. The first is that the assets become the child's property when he or she reaches the age of the majority--18 or 21, depending on state of residence--leaving the donor with no real control over where the money is spent. The second is that for college-bound children, substantial UGMA/UTMA assets will tend to work against them in financial-aid calculations.

If you're setting up a UGMA/UTMA account, my advice is to keep it simple and choose a plain-vanilla, well-diversified fund. Total market stock market index funds can make sturdy anchor holdings for UGMA/UTMA accounts.

Strategy: Contribute to a 529 Plan

Best for: Building college savings while possibly obtaining a tax break at the same time.

Overview: If you're saving for a college-bound child or grandchild, section 529 college-savings plans help you avoid the two key pitfalls of UGMA/UTMA accounts. First, the assets are the property of the account owner (in this case, you), not the child. So if your grandchild doesn't end up going to college, you can use the 529 assets for another grandchild. Second, because 529 plan assets are considered to be the property of the account owner, they have a relatively limited impact on financial-aid eligibility. In addition, you won't owe taxes on 529 plan investment earnings from year to year, and withdrawals from a 529 plan account will be tax-free provided you use them to pay for qualified higher-education expenses such as tuition and room and board. Finally, you may be eligible for a state tax break on your contribution; this article discusses the value of those tax advantages on a state-by-state basis.

Even though 529s have generally improved over the years, their quality is still uneven and some plans are costly. Morningstar's 529 Plan Center helps you assess the pros and cons of your state's plan; the 529 plans from Maryland, Ohio, and Nevada are among our favorites.

Strategy: Fund a Roth IRA

Best for: Saving for the long haul, especially for older children.

Overview: If your grandchild is older and working, you can contribute an amount equal to his or her earned income, up to $5,000, to a Roth IRA. As with a UGMA/UTMA account, you can put a huge range of investments inside a Roth wrapper; there are no investment minimums or age limits on contributions. The money inside the Roth can grow tax-free until retirement, and the vehicle also offers some flexibility for withdrawals before that time. Specifically, contributions to a Roth IRA can be withdrawn at any time and for any reason, to pay for college or anything else. (Those who need to tap the investment-earnings piece of an IRA will owe income tax on that portion of the withdrawal, but they'll circumvent the 10% penalty on early withdrawals if they use the money for qualified college or certain other expenses.)

Despite the big tax benefits, Roth IRAs for children carry one of the key drawbacks that also accompany UGMA/UTMA accounts: The child maintains control over the assets and can use the money for whatever he or she wants at the age of majority (18 or 21, depending on the state.)

Strategy: Give a gift of financial knowledge.

Best for: Gift-givers at all income levels.

Overview: Even if you're not in a position to make a financial gift to a child or grandchild, you can still take time to impart financial wisdom. Even for very young children, it's not too early to start discussing big-picture concepts such as the benefits of delaying gratification today for a greater payoff down the line. And if a child is slightly older, you can share some specifics of your own approach to investing; it's amazing how many great investors say they got their starts by reading the stock tables with their grandparents. You might also share a good basic book about investing: The Wall Street Journal Guide to Starting Your Financial Life is a fine entry-level book for new investors.