If you’ve never heard of a custodial account, you might think it’s some kind of housecleaning budget line item. But nope! That’s not the type of custodian we’re talking about here. We’re talking about an adult—the custodian—who looks after money for a minor. Of course, there are a few more ins and outs to it than that, so let’s take a closer look at what custodial accounts are and how they work.
What Are Custodial Accounts?
A custodial account is a savings account that an adult oversees and manages for a minor until they’re considered a legal adult. In some states this may be 18, in others it could be 21 or even up to 25.
A custodial account may be made up of cash or it could be a bunch of different things like securities, real estate, even art. Custodial accounts are flexible. But just because they’re flexible doesn’t mean the custodian can do whatever they want with someone else’s money.
The custodian has what’s called a fiduciary responsibility to the person whose account they oversee. Basically, they’re ethically and legally required to act in the best interest of the minor. Custodians are typically a parent or guardian.
Types of Custodial Accounts
Each state will have its own regulations around what is considered the age of majority—aka a legal adult—and who can be a custodian or alternate custodian. Other than that, the only main difference between the two types of custodial accounts is what kind of assets you can contribute.
Uniform Transfers to Minors Act (UTMA)
You might hear this one referred to as an “uht-muh.” UTMAs are often the preferred type of custodial account because they can hold any type of asset, not just cash or securities. That means art, intellectual property, real estate and more are all up for grabs. UTMAs are allowed in nearly every state with a few exceptions.
Uniform Gift to Minors Act (UGMA)
Unlike an UTMA, UGMAs are limited to only financial assets—things like cash, securities, annuities and insurance policies. All states allow UGMAs. It’s also possible for minors to have both UTMAs and UGMAs set up in their name.
How Custodial Accounts Work
Now that we know what custodial accounts are, let’s talk about how they work.
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Most of the time, custodial accounts are opened by a loved one for a minor. And the same person who opens the account becomes the custodian. But that’s not always the case. Custodians can be hired or even appointed to the role. Whoever ends up with the job, they’re responsible for how to invest the assets in the account.
Custodians may have control of the account until the minor is of age, but there are limits to their power. Remember that fiduciary responsibility we talked about earlier? Many financial institutions, to protect the ultimate account holder (the minor), won’t allow a custodian to make risky decisions with someone else’s assets. For instance, a custodian might get some pushback if they’re trying to buy on margin, which is basically like taking a loan from a brokerage to buy stock.
Custodial accounts’ flexibility makes them attractive. Not only are there no contribution limits or withdrawal penalties, but withdrawals can be used for anything that benefits the minor. Pretty vague, huh? Those benefits could be tuition, a place to live, money for private-school uniforms—as long as it benefits the minor, it’s fair game. A designer dog? Not so much. Approval is required from the custodian to make withdrawals.
It’s important to mention, too, that once a contribution is made, it belongs to the minor. Anyone can make a contribution, but it’s no take backs after the deal is done. That also means the custodian can’t make a withdrawal and buy themselves a new car or put a down payment on a house. And assets can’t be moved between different children’s accounts.
Now, what happens when the minor reaches the state’s legal age? The minor takes official control of the account and all the assets in it. They can cash it out, sell the investments, keep it open and continue investing—it’s totally their call.
So herein lies one of the big risks of a custodial account: Do you want an 18–25-year-old handling what could be many thousands (or more) of dollars’ worth of assets? If you’ve been able to teach strong money management skills over the years, maybe this isn’t such a scary idea. But if there’s even the least bit of concern, be sure you know what you’re getting into and what could happen to the funds later, especially if it’s a sizeable amount.
How to Open a Custodial Account
Custodial accounts are easy to set up. The process for opening one is just like any other bank or brokerage account. You can walk into a bank or credit union, or go online, and set one up.
Again, there is no minimum deposit or contribution limits to keep in mind. Just be prepared to assign a custodian if it won’t be you.
Tax Advantages and Disadvantages
Alright, here’s where the nitty-gritty comes in. Of course, funds and assets sitting in a custodial account don’t just get to live there without some attention from the IRS. And it’s not just the IRS that has something to say about these accounts. For people who choose to open a custodial account to save for their child’s college fund (instead of an Education Savings Account or a 529 plan), it could have some not-so-great consequences. Let’s dig in a little deeper.
Once upon a time, custodial accounts used to be a nice little tax shelter for parents. Why? Because the assets in the account were taxed at the child’s tax rate, which is lower than the tax rate for adults. But the IRS caught on to this loophole and closed it right on up!
What has remained though is that because the IRS considers the minor the owner of the account, earnings are taxed at a child’s rate to a point. Here’s how that works:
If you’re still the custodian. If you’re still the custodian of the account, meaning the account holder hasn’t legally become an adult, then the first $1,100 of investment income is tax-exempt. The next $1,100 is taxed at the child’s rate (usually between 10–12%). And then anything over $2,200 is taxed at the trusts and estates tax bracket and rates.1 This rate could be higher than the parents’ rate, depending on income.
If you’re no longer the custodian. If you’re no longer the custodian of the account because the account holder is now legally an adult, you can still get a tax advantage. Custodial account holders younger than 19, or 24, for full-time students, who still file on their parents’ tax return are allowed up to $1,100 of their investment income to be tax-exempt, even after the account is turned over to them. Then the next $1,100 is taxed at the child’s rate. And from there, any unearned income over $2,200 is taxed at the parents’ rate.
To anyone considering a custodial account for a college savings plan, listen up! You’ll want to be super careful here. The assets in a custodial account count toward a minor’s total financial assets. That can throw a really big wrench in things come college time. Having money stashed in a custodial account could lower your financial aid eligibility, including cutting down or eliminating access to other government or community aid. Yikes! You definitely want to talk to a tax or investment professional before you move forward with a custodial account.
College aid eligibility aside, there’s another tax disadvantage you’ll want to keep an eye out for. While there aren’t any contribution limits on a custodial account, keep in mind that any gifts of $15,000 or more in a year ($30,000 for a couple) may be subject to a gift tax.
Choose the Right Account for You
If you’re saving for your child’s future, specifically college, don’t move forward with a custodial account until you’ve talked with a SmartVestor Pro. Our SmartVestor program will put you in touch with a qualified investment professional near you. They’ll not only help with a plan, but they’ll also make sure you understand how everything fits together.