In the past four years, we've seen record returns of more than 20 percent annually in the stock market, as measured by the S&P 500 (explained in Understanding Financial Terminology). You know that today you can't get 20 percent interest on your savings account. So, buoyed by the opportunity to make more in the market than with other types of investments, many people have put their money into stocks. They're also putting their kids' money into the market, and now kids are putting their own money in. Essentially, they're becoming stockholders.
Someone who owns a part of a company is called a shareholder (or stockholder). The name comes from the fact that ownership in a company is evidenced by a piece of paper called a stock certificate. Each unit of ownership is called a share.
A bull market means that stock prices have been rising over time. The opposite of a bull market is a bear market. Here, stock prices fall over time.
Two basic types of shares exist: common stock and preferred stock. Common stock is the most common. Preferred stock offers certain special rights, such as preferential dividends.
If you're in the stock market, how do you put 20 percent into your pocket? It's not like a savings account that pays out interest each year. With stocks, the returns primarily come in the form of appreciation. This is really just a fancy way of saying that the price of the stock increases from the price you or your child paid for it.
The stock market as a whole may rise or fall. Today, we're in an unprecedented bull market where prices have been steadily rising for nearly a decade. But just because the market in general goes up is no guarantee that the price of an individual share will also increase. Market changes are measured by indexes, explained later. These indexes may not account for movement, up or down, in a particular stock.
Stocks offer another benefit: Not only can you enjoy a substantial return on your investment, but you also get a tax break. When stock is sold, you're not taxed on all the proceeds from the sale; you're taxed only on the profits (called gain for tax purposes). This is simply the difference between what you paid for the stock (including any commissions and fees)—your basis in the shares—and what you get for it on the sale. That gain may be taxed at special rates. While salary, interest, and most other income is called ordinary income and is taxed at rates ranging from 15 percent to 39.6 percent, capital gains on stock held for more than one year is subject to a 20 percent tax rate. For people in the lowest tax bracket of 15 percent, which includes most kids, the rate for capital gains is only 10 percent.
Watch Your Step
If your child is under the age of 14 and has income of more than $1,400 in 1999, then capital gains are taxed to him at your capital gains rate. So, if you pay 20 percent on your capital gains, he will, too.
Of course, not at all stock picks may be winners, but even losses get special tax treatment. They can be used not only to offset gains, but up to $3,000 of losses are deductible against ordinary income.
It's important to keep these tax considerations in mind. After all, it's not what you make but what you keep after tax that's important. So, if your 16-year-old child works a part-time job and pays 15 percent tax on her income, she's not doing as well as if she invests money in the market and pays only 10 percent on her gains.