What is a Custodial Account – Investing for Your Children
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Parents are always looking for ways to secure their children's financial future. Looking at the inflation, their concerns are genuine. You can invest in your little one's future and make the most of the benefits of compound interest by starting early. It is possible to start investing for your child by opening a custodial account.
It is an account that allows you to transfer funds to the minor, and your money will remain safe till the child comes of age. Besides starting their investment journey through the account, you also enjoy tax advantages. You can choose from the different types of custodial accounts and consider their pros and cons. Here is a complete guide on a custodial account and how it works.
The custodial account is a financial account that you can open and maintain for another person. It works like a savings account or a brokerage account for the child. You have complete control over the account until your child turns 18. After the child is of age, they can take ownership and control the account according to their wishes.
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Types of Custodial Accounts
There are different types of accounts, and you must understand each one to choose the one that is ideal for your needs. There is a UGMA account and a UTMA account. They are similar in how they work but differ in terms of the types of assets held within each.
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Uniform Gifts To Minors Act
Uniform Gifts To Minors Act (UGMA) is a custodial account set up by the parents, grandparents, relatives, or guardians of the child who then serves as the account's custodian until the child reaches the age of majority in the state. Most states have the legal age requirement of 18, while many others are 21 years or older. If family or friends contribute to the UGMA account opened through a stockbroker or a bank, they will not be subject to the annual contribution limits. But these financial gifts are irrevocable, and this means they cannot be taken back from the minor after the transfer. This is why it is essential to speak to a lawyer or a financial advisor before setting up the account.
The account can hold pure financial assets like stocks, cash, mutual funds, life insurance policies, bonds, and other financial instruments.
Uniform Transfer to Minors Act
Uniform Transfer to Minors Act (UTMA) is also a custodial account set up by parents or other custodians. There is no limit on the dollar amount you contribute each year. It can hold any property, which means it can hold pure financial instruments and real estate property. You can place a deed to a car into the account and transfer its ownership to the minor. South Carolina and Vermont have not allowed UTMA accounts.
An Education savings account is also another type of custodial account that can be used to save up for the child's higher education. It is a great alternative to other education saving accounts like the 529 college savings plans. The money earned on the investment account will be tax-deferred, and withdrawals made for education will remain tax-free. But the account is only available for individuals and families that fall under a specific income level, and there is a maximum contribution limit of $2,000 annually to the ESA.
You can also open custodial Individual Retirement Accounts (IRA) for the minor. You can open a traditional IRA or the Roth IRA, and the benefits and rules to the respective account will apply.
Which is the best account for kids?
Now that you know the types of custodial accounts, you need to decide which one is ideal for your child. When deciding where to open an account, you will have several options, but you need to decide the type of account first. Here are some things you must keep in mind before making a decision.
Investment products: Consider the types of investments you want to make from the account. If you invest in real estate, you will need to choose the UGMA account since others offer a limited range of investment choices.
Fees: This remains an important consideration when choosing an account. Most custodial accounts will have low or zero fees if you are already a customer with the brokerage firm. Some may charge trading commissions, while some offer free stocks when you sign up. Hence, check the fees and compare the services before signing up.
Account minimums: Look into the minimum initial deposit you need to make and the account balance you need to maintain regularly.
Related: How to Invest as a Teenager
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Opening a custodial account
It is easy to open a custodial account. Most online brokerage firms offer the account, but it helps to compare the fees before signing up. Simply choose the brokerage firm or mutual fund company you want to work with and provide information about you and the account's beneficiary. Next, you will have to give details like your social security number, address, and contact information. Once you fund the brokerage account, you can start investing.
Funding the custodial account
The transfers you make to custodial accounts are considered a gift. Each parent and grandparent can give their child $16,000 annually ($32,000 from a couple) without using any gift tax exemption. This amount is also known as annual exclusion. You can coordinate the gifts to the account with any other gifts to qualify for an annual tax exemption.
If the donor and the custodian are the same individuals, the balance in the custodial account will be a part of the donor's estate in case they die while acting as the custodian. It is a task for parents but even more risky for the grandparents, so they should stay away from acting as the custodian of the account they fund. When grandparents create the account and appoint the parents as custodians, the assets in the report will become a part of the parents' estate and will not be included in the grandparents’ estate.
How are custodial accounts taxed?
Before opening a custodial account, you need to consider the kiddie income tax rules. This means that when you have any investment income earned in the account, whether through dividend, interest, or capital gain on the assets held in the account, it will fall under the child tax rate after they attain majority.
When the child is a minor, the first $1,1,50 will remain untaxed, and the balance of $1,150 will be taxed at the kiddies tax rate. Once the account has earnings exceeding $2,300, it will be subject to the rate as a parent, and the income will be considered investment income.
Who should get a custodial account?
A custodial account can help save for the future of your child. When you start investing at a young age, you will know that as your child grows, they will also have money maturing for higher education. Consider the tax benefits as extra bonuses. But custodial accounts are not for everyone. You should think through all the available options before deciding if the account is for you. If you want to make the most of the financial aid, you need to think twice before opening the account since the custodial account assets will be considered the child’s assets when they apply for aid.
That said, if you are not sure if your child will be able to control the account once they attain majority, a custodial account may not be for you. You will continue worrying that your child will irresponsibly spend the money, and it may not serve the purpose of the account.
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Pros & Cons
Pros
- No upper limit: A custodial account limits income or distributions and offers flexible rules and regulations. You can also withdraw from the account without attracting any penalty. This makes it a low-maintenance way to open an account for the child.
- Highly flexible: Several people choose a custodial account to work as a college fund, making withdrawals easy for other purposes. Hence, the custodian can withdraw from the account for any expense that can be used for the benefit of the minor.
- Easy to transfer: It is easy to transfer assets to the beneficiary through custodial accounts. After the beneficiary turns 18 or 21, they will take control of the account, and it will not need any legal help or expertise to execute.
- Tax benefits: You can make the most of the tax benefits offered on the custodial account. If children file on the parents’ tax return, they can claim the fund assets at a lower tax rate.
Cons
- Has an impact on financial aid: You can create a custodial account to help with college funds, but it can also count against the child when you apply for financial aid. The assets in the fund are counted towards the overall income and could bump your household income bracket.
- Restriction on the tax breaks: Only the first $1,150 contributed to the account is considered tax-free, and any amount over and above it will be taxed.
FAQs
Is it possible to take back the assets once I’ve set up the custodial account?
No, you can't take back the money and assets you have deposited in the account. It is irrevocably and immediately the property of the child.
What is the responsibility of the custodian?
As a custodian, your responsibility is to manage the assets for the minor until they attain the majority. You can also designate another adult to be the account’s custodian.
Who will have control of the account once the child attains majority?
After the end of the custodianship, the account holder, who is now an adult, will have complete control of the account and its assets. The control of the custodian may be restricted. The account holder can then choose to see the investments in the account or even close the account. They can also convert the account to their name.
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- Get $5 to Make Your First Investment
- Invest in Stocks and ETFs with $1 or Less
- Receive Your Paycheck up to 2 Days Faster
- No Overdraft Fees or Minimum Balances
The bottom line
A custodial account is a great way to secure the child’s future. It is also an excellent way to make a financial gift to the child while making the most of the tax benefits. You can also provide basic investing skills to the child through this account. Talk about goals and investment options and teach them the benefits of compounding interest. If needed, seek the help of a financial advisor before opening the account.
You have plenty of investment options out there worth exploring. But if you want to save for your children who are the most important in your life and keep the assets in the account without any restrictions, a custodial account can be a perfect vehicle for you.
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Writer
Vandita Jadeja is a financial writer and editorial assistant at Joywallet. She loves to read and write about money and brings 7 years of experience from the financial industry. She loves coffee, mountains and sunsets.
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