Teach Kids to Diversify Their Investments
Dividends are payments by companies to people who own stock in them. Dividends usually are paid in cash, but they can also be made in stock or other property. For example, if your child owns one share of McDonalds, he'll earn a 36¢ cash dividend on that share for the year.
Capital gain distributions are paid by stock mutual fund companies. This represents capital gains the funds have received on selling the stock they've held. It's paid to fund holders like a dividend, but it gets more favorable tax treatment.
Income Versus Growth
Two main categories of investments exist: those that produce a fixed income, and those that go for growth. Fixed income mainly means interest income earned on savings accounts, bonds, and similar investments.
Other types of income relate to non-fixed income investments, such as stocks and stock mutual funds. These two types of income include dividends and capital gain distributions from mutual funds. This income is paid when companies make money and share their good fortune with their shareholders.
Fixed-income investments offer your child certainty. She knows when she buys a fixed-income investment exactly what she'll have when she's through. For example, if she buys a CD paying 5 percent interest for five years, she can figure today to the penny what she'll be paid five years from now.
Fixed-income investments, however, don't offer any possibility that they'll be worth more than expected later on. There's no possibility for growth.
Growth investments, which include stocks and stock mutual funds, are so named because they're held primarily for the chance to have the investment grow in value over time. This growth in value is translated into more money when the stock or fund shares are sold and result in capital gains.
Capital gain is the appreciation in the value of assets since they've been bought. If your child paid $25 for a share of stock and sells it when the price has risen to $100, the $75 appreciation is capital gains; it's another word for profit.
Adults are always talking about capital gains, and this topic is important for two reasons.
- Capital gains are taxed only when something is sold. So, if your child buys Microsoft and the value of the stock rises by 200 percent, there's no immediate tax to him. The size of his savings has grown because of increases in the price of the stock he owns.
- Capital gains receive special tax treatment. Unlike ordinary income, such as salary, interest, or dividends (which is taxed according to graduated tax rates running from a low of 15 percent to a high of 39.6 percent), capital gains on assets held more than one year have a lower fixed rate of tax. Generally, they're taxed at 20 percent, but people in the lowest tax bracket on their other income pay only a 10 percent capital gains tax. For example, if your 16-year-old's only income for the year is a $3,000 salary, $1,000 in interest and dividends, and $5,000 in capital gains, the portion of his ordinary income that's taxable is subject to a 15 percent tax rate; the capital gains is taxed only at 10 percent. (For kids under 14, the kiddie tax can make them pay the 20 percent adult rate on their capital gains.)
Even without selling growth investments, your child can receive income from them. As explained earlier, growth investments may throw off income in the form of dividends or capital gain distributions by mutual funds.
As you've seen, kids have long time horizons for investments and so can wait out the ups and downs of the stock market. They can expect that over the long haul, as has been historically true, stocks will perform better than fixed-income investments. But your child may need money for something that's coming up—buying a car, going to college, starting a business. If the money is targeted for certain special uses, you may have to adjust allocations over time.
- Very young children. Here, allocations may be weighted more heavily toward growth investments. It's still many years away until college or other needs for the money.
- Mid-teens. If money is intended for college, then most experts agree that when your child is about three or four years away from starting, some or all of the money in growth investments should be shifted into fixed income. This will assure that the money needed for tuition will be there even if the stock market dips at the time your child enters college.
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Excerpted from The Complete Idiot's Guide to Money-Smart Kids © 1999 by Barbara Weltman. All rights reserved including the right of reproduction in whole or in part in any form. Used by arrangement with Alpha Books, a member of Penguin Group (USA) Inc.
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