Table of Contents:
- Two types of custodial accounts
- How to use a custodial account
- Custodial account pros and cons
- Custodial account options
- The Bottom Line
When it comes to finances, the more we know and understand, the more control we can have over our financial futures.
Many parents realize that to give their kids the best chance of financial success, they need to set aside some time to teach their kids fiscal responsibility, and a custodial account for minors can be a beneficial tool to do so.
You may be wondering what’s a custodial account? A custodial account refers to a financial account that’s set up for a minor beneficiary but managed by a responsible adult— a custodian or guardian who is bound by a fiduciary duty to the beneficiary.
A fiduciary is a person or institution that acts on behalf of another person, with the beneficiary’s best interests ahead of their own. In the case of a custodial investment account, it’s the adult guardian, such as a parent or grandparent, putting the child’s best interests first. A fiduciary is bound ethically and legally to act in the minor’s best interest.
Key Takeaways:
- 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 $16,000 per person.
Two types of custodial accounts
When choosing to set up a custodial account, there are 2 main types to choose from: a Uniform Transfers to Minors Act (UTMA) account or and the older version, a Uniform Gift to Minors Act (UGMA) account.
Both types of accounts are set up in the minor beneficiary’s name along with the custodian’s name. This can be a parent, grandparent, or legal guardian. The accounts are very similar in how they work, but they differ in what types of assets they can hold.
A UTMA account can hold just about any type of asset, including cash, real estate, artwork, and intellectual property, such as patents, copyrights, trade secrets, and trademarks. Whereas UGMA accounts are limited to assets only financial in nature, such as cash, stocks, bonds, mutual funds, and insurance policies.
Both accounts are valid in nearly all states in the U.S.
How to use a custodial account
When it comes to preparing a child for the future, giving them a head start financially can be beneficial. Whether you want to help them with college savings, financing a special occasion, or building a nest egg for their future, custodial accounts can help you get there.
It’s easy to open a custodial account as it’s just like opening any savings account or brokerage account. Along with the minor’s personal information and social security number, you’ll also need to provide your own as the custodian of the account.
After it’s set up, a custodial account works just like any other bank or investment account. The custodian manages the account and can make deposits and invest as they see fit as long as it benefits the minor.
The account custodian can choose any type of investments allowed by the specific account, as listed above. However, before the child becomes of legal age, the custodian will make all investment decisions for the account with the minor beneficiary’s best interests in mind.
When the minor becomes of age in their state of residence, usually 18 to 21 years old, the account transfers to them. They assume control over that account, including any taxes associated with the account.
For example:
Dave and Sue have a child named Joe. They plan to save for medical school and open a custodial account to do so. They choose a Uniform Transfers to Minors Act (UTMA) account which allows Dave and Sue to make gift donations in the form of intellectual property, artwork, cash, real estate, and investments such as stocks, bonds, and mutual funds.
Since there aren’t limits on how much they can contribute to the account and understand the expense of medical school, they spend the next 18 years putting assets into the account.
Joe is a good kid but isn’t a great student. He hates the idea of medical school and wants to skip college altogether to work on his artistic talents as a writer, painter, and musician.
His parents aren’t happy about his plans. Still, when Joe turns 18, which is the legal age in his state of residence, he gains control of his UTMA account and begins using the money to pursue his own goals.
Although Dave and Sue are disappointed, there’s nothing they can do as the account is irrevocable. All control over the assets in that account now belongs entirely to Joe, who gets to decide how he uses the money.
Custodian accounts vs. trust funds
When it comes to planning for a beneficiary’s financial future, the most important goal usually comes down to finding the method that allows the beneficiary to receive the gift you intended in a way that makes the most sense.
There are 2 main options to consider when choosing how to leave assets to a minor and include a Uniform Transfers to Minors Act (UTMA) account and trust funds. They each have both benefits and drawbacks to consider before making a final choice.
Trust fund basics
A trust is a legal document that grants a beneficiary assets as spelled out in the document and owned by a trust. It may have detailed rules associated with managing it and may include a specific set of terms.
Some of those terms can include parameters such as the beneficiary must graduate from college or only receive a specific amount of money in payouts instead of being awarded the entire trust.
Trust advantages
- A trust allows you to dictate the terms of the trust as well as how and when assets can be distributed.
- Trusts protect assets from financial hardships and bankruptcy if the account’s trustee has financial troubles.
- Trusts protect privacy and can eliminate the need for probate in the event of a death.
Trust disadvantages
- Trusts are costly and time-consuming to set up.
- Trusts limit flexibility and must abide by the terms set.
UTMA basics
As discussed earlier, UTMA accounts are types of custodial accounts in the name of the beneficiary where financial gifts and property can be given to a minor. Under the rules in which a UTMA account works, the minor beneficiary is the owner of the account but has a custodian that manages that account.
The account management stays with the custodian until the minor becomes of legal age in their state of residence. Then, the account is transferred to them, and they assume all responsibilities of managing the account.
Custodial account pros and cons
While custodial accounts have a variety of benefits, they come with some disadvantages as well.
Custodial account pros
- One of the benefits of a custodial account is the flexibility associated with it. With no contribution limits, custodial accounts offer a way to provide a variety of assets to the account. They also don’t have any distribution requirements or penalties for withdrawing assets.
- Although withdrawals are only to be utilized in the best interest of the beneficiary, the parameters of how the assets are used aren’t specified and can be used for such things as clothing, college expenses, rent, or anything else the beneficiary needs.
- The custodial account is transferred to the beneficiary once they reach legal age in their state of residence.
- Custodial accounts are simple to set up and can be less costly than a trust.
- Since the minor owns the account, they are allowed the first $1,150 of unearned income tax-free. After that, there’s a low tax rate associated with the account.
Custodial account cons
- Children’s custodial accounts are not tax-free, and although the first $1,150 of unearned income is allowed to be untaxed, all gifts after that are subject to tax.
- Since the minor owns the assets in the account, it may impact the minor’s ability to get financial aid or be eligible to receive government aid or community aid.
- Any gifts that are awarded become the property of the beneficiary and can’t be taken back by the custodian for any reason.
- Since the minor owns the account and is irrevocable, the beneficiary can’t be changed, and gifts can’t be reversed.
It’s important to remember that the child will grow up and gain access to the account with complete control of the assets at a fairly young age, usually between 18 and 21.
It won’t matter if they’re not mature enough to handle that responsibility or don’t understand finances because by then, nothing can be done. So knowing what a custodial account is and the rules involved is vital before choosing to open one, as they are irrevocable the minute they are opened.
Custodial account options
Finding the right brokerage to open your custodial account isn’t too difficult, as you have plenty of choices by searching for online brokerage accounts. You’ll want to choose one that offers custodial accounts and doesn’t have any account fees or minimum investment requirements.
As your child grows, it’s a good idea to begin teaching them about money management and investing. Allowing them to choose some of their investments and watch how they do is a great learning opportunity for them.
The bottom line
Providing for a child’s financial future is an amazing gift. Answering the question, what is a custodial account and learning how it can be beneficial can be a good start as long as you understand how they work.
Opening a custodial account is easy, as they resemble accounts like savings accounts and custodial stock accounts, which allow a guardian to manage the account and all decisions made as long as the child’s best interest is the goal. There are both tax benefits and risks associated with custodial accounts, and understanding them is crucial.
Learning the basics of how to invest in stocks can help in making decisions about what investments would be most beneficial to meet the goals you have for your child’s future.
Although the risk of loss does exist, investing is one of the many ways to help you save for long-term goals such as a new home, future travel, or a retirement. Of course, it’s important to learn how stocks work and remember, the earlier you start, the better, so download the Public app. And get started today!