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Custodial accounts: Invest for your kids
Invest so a child can get a head start when they come of age.
Interested in setting up an investment account for your kid but don’t know where to start? We’ll walk you through the different types of custodial accounts, some of the benefits and drawbacks that come with these accounts and what you can expect when opening an account.
Custodial accounts defined
Custodial accounts are a type of investment account set up by an adult for the benefit of a minor. The minor owns the account, but the assets in the account are controlled by the custodian until the minor becomes an adult. For most states, this is 18 or 21, but some states allow the transferor to stipulate that the minor can’t take ownership of the account until age 25.
There are several types of custodial accounts, but the most common are UGMA accounts, UTMA accounts and custodial IRAs.
3 types of custodial accounts
The following three types of custodial accounts allow you to save and invest for a minor, but they differ in tax implications, contribution limits and the types of assets that can be gifted.
Uniform Gifts to Minors Act (UGMA) account
UGMA accounts allow custodians to gift money and financial securities like stocks, bonds, mutual funds and life insurance policies to minors. UGMA accounts are available in every state, and there’s no limit to how much you can contribute.
Uniform Transfers to Minors Act (UTMA) account
UTMA accounts are similar to UGMA accounts except they allow any kind of property, such as precious metals, real estate and art, as well as cash and securities. This makes them ideal for custodians who have more risky assets or tangible assets they want transferred to the minor.
Like UGMA accounts, there’s no contribution limit. But UTMAs aren’t available in every state. If you live in South Carolina or Vermont, you’ll need to go with a UGMA.
Custodial individual retirement account (IRA)
Custodial IRAs allow an adult to save for a minor in a retirement account, provided the minor has earned income. Custodial IRAs include both traditional and Roth IRAs and are subject to the same tax implications as their regular versions. They’re also subject to the same contribution limits. For 2022, you can contribute up to $6,000 or the total of your child’s earned income for the year.
But like regular IRAs, money withdrawn before age 59 ½ without a qualified exception are subject to taxes and an early withdrawal penalty.
Anyone older than 18 can open a custodial account
While a parent may be the most likely person to open a custodial account, any adult can open and contribute to a custodial account on behalf of a minor. Once opened, the custodian manages the assets in the account until the minor becomes a legal adult, at which point the account transfers to them.
The age of majority is between 18 and 21 years of age, depending on the state. In some states, the transferor can specify that the beneficiary be 25 to receive the gift.
Benefits and drawbacks of custodial accounts
Custodial accounts make it easy to give financial gifts to a child, but these accounts have some drawbacks, too.
- Efficiency. Custodial accounts offer an easy way to transfer a financial gift to a minor without setting up a trust.
- More affordable than setting up a trust. Custodial accounts are easier and cheaper to set up than trusts. Trusts can be complicated. Hiring a living trust lawyer can cost between $1,000 and $2,000.
- Variety of assets. Custodial accounts can hold cash, stocks and bonds as well as physical assets like precious metals, artwork and real estate.
- Flexibility. Custodial accounts don’t have income or contribution limits, and withdrawals can be used for anything benefitting the child.
- Tax advantages. The first $15,000 contributed to a UTMA or UGMA account can be gifted without incurring the federal gift tax. With a custodial traditional IRA, contributions are tax-deductible. Contributions to a custodial Roth IRA grow tax-free.
- Can reduce the minor’s eligibility to receive financial aid. Custodial accounts are the minor’s assets and can impact their ability to receive financial aid. Colleges expect up to 20% of an independent student’s assets to pay for college.
- Assets are irrevocable. Once assets are transferred, you can’t get them back. When the beneficiary comes of legal age, they control the account and can use the funds however they want.
- Contributions aren’t tax deductible. Contributions made to a custodial account are not tax deductible when it comes time to file.
How are custodial accounts taxed?
Adults can contribute up to $15,000 a year to UGMA and UTMA accounts free from federal taxes. The minor is required to pay taxes on anything over this amount.
UTMA and UGMA accounts are subject to a “kiddie tax.” If the child’s income from interest, dividends or other unearned income is more than $2,200, you’ll pay tax at the rate of the child’s tax bracket for trusts and estates.
If the child’s only income is from the interest or dividends earned in the account and totals less than $11,000, you can include the amount on your return rather than filing a separate return for your child.
Custodial IRAs are taxed just as regular IRAs. Contributions made to custodial traditional IRA are tax deductible for the year the contributions are made. With custodial Roth IRAs, on the other hand, contributions are made with after-tax dollars and grow tax-free for the child’s lifetime.
4 steps to open a custodial account
Adults can open a custodial account at banks, credit unions, brokers and financial services companies. Each financial institution will determine its own requirements for opening an account, but here’s generally what you need to do to open a custodial account.
- Choose a bank, brokerage or other financial institution. Compare your options to find the one that works best for you and your beneficiary. Look for things like fees and commissions, account minimums and reliability.
- Decide on an account type. If your child doesn’t have earned income, a UTMA or UGMA account might be the best option. If your child has earned income, a custodial IRA might make more sense.
- Open and fund your account. Have your ID, Social Security number and bank account information available, as well as employment details if you’re employed. Once the account is established, link it to a bank account or brokerage account so you can fund the account.
- Decide what to invest in. Help your kid pick individual stocks or build the entire portfolio with index funds, mutual funds or ETFs.
Compare brokers that offer custodial accounts
Custodial accounts make it easy to to transfer assets and financial gifts and invest for your kid. They’re less expensive and simpler to set up than trusts. But remember that custodial accounts can reduce your kid’s eligibility to receive financial aid for college and assets in the account are irrevocable. Once you transfer the assets, you can’t take them back.
If a custodial account sounds right for you and your kid, determine the type of custodial account that works for you, choose a broker and help your kid start investing.
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