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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:
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 done well over the course of the last four years, averaging about 14% annualized return (we are hoping but not counting on this type of growth in the future). Finally, 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, this is the seventh cycle of investing (2001, 2002, 2003, 2004, 2005 and 2006, 2007) and for the second portfolio this is the fourth year of investing (2004, 2005, 2006, and 2007). The third portfolio just started in 2007 and my niece has been great about saving up her money to get the full value of the "match". I didn't have any expectations going in if boys or girls would be more or less interested in this process but it seems like (based on my limited sample) everyone seems to "get it".
Note - if you want to read a great book about inheritances and estate planning, get "Beyond The Grave - the Right Way and the Wrong Way of Leaving Money to Your Children (and Others)" by Gerald and Jeffrey Condon. The book is actually highly entertaining (I realize that is hard to believe about such an inherently depressing subject) and very practical, although it is more at a high level than at a detailed level. I also gave the book "Investing for Dummies" to one of my nephews with a written commentary - this is a good introduction to the world of investing.
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 progress 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 - they keep moving these pages around so it is easier to search for it than for me to link to it (plus I technically shouldn't link to anywhere on their site except for the main page).
Vanguard brokerage services seem to work pretty well. It is about $22.50 / trade, slightly more for stocks under $1 / share or for very large lots. There was an annual fee of $30-$50 / year for maintenance of each brokerage account in the 2003-4 time frame, but my current brokerage account is no longer charging this fee. I think this varies by provider - and they are smart to not have this fee, because I am essentially creating a customer for them that can stay with them for years. These rates will vary if you set up the fund somewhere else (i.e. Fidelity). You can shop around for cheaper rates, as well. Given the relatively small amount of trading I do in each fund, these fees aren't crippling on my level of investment. Probably if you are setting them up "from scratch" today you can do a bit better.
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."
Under this account, any gains / losses on the sales of stock are taxable for the child. They are also taxed on the interest received (the money goes into a money market fund tied to the brokerage account and earns interest before it is invested) 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.
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. 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.
Down the road I may add a matching bonus to encourage other responsible financial behavior, like filling out his own tax form, balancing his checking account, or creating a budget and sticking to it. We will see if this is necessary or helpful. I don't want to come across as overbearing or the whole process won't be fun anymore.
Results of the Trust Fund (updated October 2008) & How To Calculate Performance
This section has recently been updated with portfolio results through October, 2008. Each portfolio should print out in landscape form on a single page.
Portfolio One financial results for the years 2001 - October 2008
Portfolio Two financial results for the years 2004 - October 2008
Portfolio Three financial results beginning October 2007 - October 2008
These financial results have been put together in an organized way to understand financial performance. You can see:
- the cost and # of shares for active stocks in the portfolio
- the "realized" gain or loss on stocks that USED to be in the portfolio, along with the year of the sale (needed for income tax purposes)
- the dividends earned on each of the stocks and their "yield" or forecasted dividend stream given their current stock price expressed as a percentage (i.e. 3.5% is a good yield, zero percent means that the stock pays no dividends)
- fees on buys / sells are also listed in cumulative form across all the years that the portfolio has been in operation; the % of fees is annually under 1% when all costs are taken into consideration which is an important part of achieving good performance (I don't charge any fees for my role as portfolio trustee, obviously)
- there is a brief description by each stock stating the outlook, and for sales what the sales price is as of the current stock price (for all those Monday morning quarterbacks out there)
- the interest earned on the money market fund that is part of the brokerage account since inception
- the cumulative rate of return based on the cashflows "in" (my $1000 / year contribution and their $500 / year contribution), the number of years, and the current balance. This number isn't perfect but is reasonably close.
NOTE ON RECENT PERFORMANCE:
These portfolios were updated as of October 11, 2008. This date is the weekend after the horrible US and world wide stock market rout. We will take some time and assess our positions and determine what to do next. Like all portfolios, we were impacted by the drop in stock prices. However, we avoided any stocks that went into bankruptcy and in "relative" terms did better than the market, although this is small consolation when we are dealing with real money.
Stock List that We are Selecting for 2008 (updated July, 2008)
List of stocks that we are selecting from for the 2008 investment round, and an update on their performance. This list was updated as of mid November, 2007. We sold some stocks that reached their limits and that we did well on, mainly in India and China where the markets went through the roof. NOTE - these are not recommendations - you should do your own research.
The Impact of Commissions and Fees on Your Portfolio:
The cost for a buy / sell is between $5 - $30 depending on your brokerage and whether you do it online or by phone, and whether or not it is a "penny stock" or not. Rates change all of the time for online brokerages. Often there will be a rate of $9.99 / trade, but only if you make a large number of trades. Rates closer to $14-$15 are more common for infrequent traders.
The execution that I have received has been very fast, nearly instantaneous from my point of view. This is probably due to the fact that they are matching my order to their inventory and I am buying very, very liquid stocks at the market price. If you are buying more exotic or less liquid securities it would probably be better to buy using a market limit order to avoid buying (or selling) at a price you don't like.
On a $1500 order, if you buy two individual stocks, you pay $22.50 * 2 or $45 which is about 3% of your total. Some vendors waive the fees, but you should also count on some kind of annual maintenance fee of approximately $15 / year for each brokerage account. Thus these costs seem smaller as the investment grows (hopefully) over time. Execution costs have been going down over the years - hopefully when each beneficiary gains custody of their account at age 21 years old brokerage costs will have declined even further (most definitely in "absolute" terms, probably in "relative" terms). The commissions and fees are listed on each of the portfolios above and their impact has been rather modest, although every dollar saved in fees is one less dollar you have to pick up on returns.
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.
The net of the above items is that 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.
What you can do to minimize the tax hit is to "step up" your basis every year up to the $1700 limit (this limit goes down when the minor starts working at 16, for example) because the first 850 in gains is tax free and the next 850 is taxed at only 10%. This means selling your winners and reinvesting the proceeds. This is generally part of an overall portfolio strategy in any case.
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. 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. 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.
Other Options for College Investing
There are many options available for college investing. One down side of the UGMA plan is that these assets are counted as being owned by the student for financial aid purposes, thus limiting the amount of financial aid that the student can receive. The complexities of these various plans are too myriad to be covered in this site, and I frankly am not an expert on the topic. For my purposes, the UGMA has been working well as has the "match" concept, so that the beneficiary feels that they have a stake in the outcome and it isn't just money that comes to them with no strings attached (this is a bad phenomenon from my point of view).
A Sample Portfolio for Your Own Investment Selections
I worked with a friend of mine to put together a simple, sample portfolio that you can use if you want to manage your investments yourself. This portfolio is designed to be used with ETF's so they are very tax efficient. Analysis was done to select a balance of investments between total return and the variability in the return.
Here is a link to the PDF showing the detail behind the selections.
| US Large Stocks | 25% |
| US Small Stocks | 15% |
| US Small Value | 10% |
| EAFE (European Equities) | 10% |
| Emerging Market Equities | 10% |
| REIT's (Real Estate Investment Trusts) | 10% |
| Short-term bonds | 20% |
| TOTAL | 100% |
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