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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.

What is a custodial account?

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.

A custodial account is a form of a fiduciary relationship, where the adult is expected to place the needs and interests of the minor in front of their own. There are several types of custodial accounts, but the most common are UGMA accounts, UTMA accounts and custodial IRAs.

Custodial funds can be used anywhere

After the minor assumes ownership of the custodial account, the funds within are useable for any purpose. Prior to that, the custodian may take out funds from the accounts only for the purpose of spending on the minor.

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.

1. 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.

2. 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.

3. 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.

Pros

  • 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.

Cons

  • 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.

Who pays taxes on a custodial account?

All taxable earnings earned through a custodial account are the responsibility of the child. However, the custodian is responsible for filing taxes on those earnings until the minor assumes ownership. This means adults are not taxed, but they’ll have to manage the taxes on the account.

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.

What about custodial IRAs?

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.

  1. 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.
  2. 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.
  3. 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.
  4. Decide what to invest in. Help your kid pick individual stocks or build the entire portfolio with index funds, mutual funds or ETFs.

Are custodial accounts a good way to teach kids about money?

While custodial accounts are a good investment for your child’s future, they’re not the best way to teach your kid about money. Custodial accounts are a hands-off experience for minors. Only the custodian is depositing funds, handling money and dealing with taxes prior to the minor taking over.

If you want your child to have more control over their money and learn about financial management, debit cards like Greenlight and BusyKid are better alternatives. These accounts not only let the minor get involved directly, but parents also have access and controls to stay on top of their kids’ spending and saving habits.

How to get money out of a custodial account

To withdraw money from a custodial account you must first offer evidence to the provider that supports that the money is being used for the benefit of the child. What qualifies as proof depends on the provider. You’ll need to contact the provider directly by phone or in person to make a withdrawal.

What happens to a custodial account after death?

If the custodian in control of the account dies, the value of the account is included as part of the custodian’s estate for tax purposes. Should the minor die before assuming control of the account, the value of the account is considered part of the minor’s estate and distributed based on state law.

Kids aren’t investing their allowance

Rather than investing their allowance, about 1 in 5 (19%) opt to keep their allowance in a piggy bank.

Bottom line

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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