A custodial account can be a benefical tool if youre looking to invest for a minor or teach them financial responsibility early. These accounts allow adults, like parents or guardians, to manage investments on behalf of a child.
But what exactly are custodial accounts, how do they work, and why should you consider opening one? In this guide, we’ll break down custodial accounts, how they work, their pros and cons, and whether they may suit your financial goals.
A custodial account is a type of investment account opened and managed by an adult for a minor. The account is legally owned by the child, but the adult (known as the custodian) has the authority to make decisions about the account until the child reaches the age of majority-typically 18 or 21, depending on the state. Once the minor comes of age, they gain full control over the account.
Custodial accounts may hold various assets, like:
A custodial investment account for minors is established by an adult for a child. It’s a type of savings or brokerage account managed by the adult until the child becomes of legal age in their state.
Opening a custodial account is one of the steps to start investing in your child’s future.
Custodial accounts offer flexibility and don’t limit contributions, deposits, or penalties for withdrawals.
Custodial accounts are excluded from gift tax for up to $18,000 per person.
When you open a custodial account, you act as the custodian, managing the investments and ensuring the funds are used for the child’s benefit. Contributions to the account are considered irrevocable gifts, meaning you cannot take the money back once it’s deposited.
For example, if you open an account for your child today, you can make investment decisions until they turn 18 or 21. At that point, the child gains full control and can use the funds for any purpose.
When setting up a custodial account, you can choose between two main types:
Uniform Gifts to Minors Act (UGMA) accounts are specifically designed to hold financial assets such as cash, stocks, bonds, mutual funds, and insurance policies.
These accounts are widely used, making them a good choice for families focusing on traditional investment assets. However, UGMA accounts are limited to financial assets and cannot hold physical property or other non-financial items.
UTMA accounts may hold a broader range of assets, including:
The flexibility of UTMA accounts allows for more diverse contributions, making them ideal for families who may want to include non-traditional assets in the account. However, UTMAs are not available in every state, so it’s essential to verify state-specific regulations before opening one.
Both UGMA and UTMA accounts allow the custodian to manage the assets on behalf of the minor until they come of age.
Understanding the types and their features can help you choose the one that aligns with your financial goals and the beneficiary’s future needs.
Read More: How to gift stocks to a child?
Custodial accounts offer a simple and flexible way to save and invest for a minor’s future. They can be used for goals like education savings, building a nest egg, or teaching kids about investing. Here’s how to make the most of a custodial account in the U.S.:
To get started, an adult (the custodian) opens the account at a financial institution. This may be a bank, credit union, or brokerage firm that offers custodial accounts. You will need:
The custodian can choose between a Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) account, depending on the types of assets they want to include.
Once the account is set up, the custodian can start funding it. Contributions may include:
There are no annual contribution limits, but remember that contributions over $17,000 per year (per donor) may be subject to gift tax.
Example:
Sarah opens a custodial account for her son, Jake, to save for his future college expenses. She deposits $5,000 annually and invests in a mix of stocks and mutual funds. Over time, these investments grow, providing Jake with funds to cover tuition when he turns 18.
The custodian is responsible for managing the account and making investment decisions until the minor reaches the age of majority (usually 18 or 21 in the U.S.).
Custodians may:
Example:
Tom sets up a UTMA account for his niece, Emily, who has shown a keen interest in ballet. Over the years, he withdraws funds to pay for her lessons, costumes, and competitions. When Emily turns 21, the remaining funds are transferred to her, allowing her to pursue her passion for dance independently.
When the minor reaches the age of majority, the custodial account transfers to them, giving them full control over the assets. At this point, the minor can decide how to use the funds.
Example:
Linda opens a custodial account for her grandson, Alex, intending to help him start a small business. When Alex turns 21, he takes control of the account and uses the funds to open his first coffee shop.
Taxes play a significant role in custodial accounts, so understanding the basics is crucial.
Each year, you can gift up to $17,000 per person (as of 2024) without triggering gift taxes. If you and your spouse file jointly, you can double that amount to $34,000.
The first $1,250 of unearned income in a custodial account is tax-free, and the next $1,250 is taxed at the child’s rate. Any earnings above $2,500 are taxed at the parent’s marginal tax rate.
Funds in custodial accounts are considered part of the child’s estate, not yours. This can be beneficial if you’re looking to reduce your taxable estate.
Read More: Gifting stocks: the guide to giving stocks as presents
Custodial accounts may offer a convenient way to invest in a child’s future, but they also come with certain limitations. Understanding the potential advantages and disadvantages can help you determine whether a custodial account suits your financial goals.
Opening a custodial account can be a thoughtful way to secure your child’s financial future. It may provide flexibility in saving for significant milestones, such as education or a first home, while enabling long-term wealth growth through investments. As you manage the account, you can teach your child valuable lessons about saving and investing that may benefit them for life.
