April 23, 2021

What is a Custodial Account

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A custodial account can help you invest in your child's future. But is it the best option for your family? Find out about the types of custodial accounts and how to use them.

What is a Custodial Account?

Technically, a custodial account is any financial account opened by one person on behalf of a beneficiary. In this article, we'll cover the most common kind of custodial account: A bank account or brokerage account opened by a parent for their child.

Fast Fact: A 401(k) is actually a custodial account. The employer acts as the custodian, while employees are the owner of the account.

Custodial accounts can be a good way to give your kids a head start on investing or to give them hands-on experience with saving money.

You get to oversee the account as the custodian. Until your kid reaches adulthood, all transactions need to be approved by you. You can also withdraw money, but only if it's used for your child or their education.

Once your child is of age (usually 18 or 21), the child gets full control of the account.

You can also get some tax benefits. But there are drawbacks to these accounts too. Learn more about the pros and cons of custodial accounts down below.

Types of Custodial Accounts

A custodial account offers a lot of flexibility for you and your child. Here are three common account types and how you can you use them:

UTMAUGMACoverdell ESA
Assets used forAnythingAnythingEducation only
Types of assetsAny asset, including propertyCash, securities, annuities, insurance policiesCash
Contribution limitsNoneNone$2,000/year

Custodial accounts are not the same as guardian accounts. Guardian accounts can belong not just to kids, but to adults who can't manage their money because of mental or physical disabilities. A court order is needed to set up a guardian account.

Uniform Transfer to Minors Act (UTMA) Account

UTMA accounts are a really flexible way to transfer just about any type of asset to your kid. These accounts can hold cash, stocks, real estate, artwork, and more. And it's easier and cheaper to set up than a trust.

There are no contribution limits or income limits with a UTMA account. The main restriction is that funds in the account need to be used for your child's benefit.

If you live in South Carolina or Vermont, however, you won't be able to take advantage these accounts. These are the only states that don't allow UTMA accounts. Find out which type you can use instead up next.

Uniform Gift to Minors Act (UGMA) Account

UGMA accounts are very similar to UTMA accounts. The biggest difference is that UGMA accounts can only hold financial assets like cash, stocks, bonds, mutual funds, and insurance—no real estate or other property.

Other than that, both accounts function pretty similarly. There are no contribution limits or income limits. And custodians can deposit and withdraw money as long as it's for the child's benefit.

Even though there are no contribution limits, keep in mind that you might have to pay the federal gift tax. (Keep reading to see if this could apply to you.)

Coverdell Education Savings Account (ESA)

The third account is narrower in scope. Coverdell ESAs are meant for education savings only. It can be a good alternative to a 529 plan.

Coverdell ESAs let you contribute up to $2,000 per child every year. These are after-tax dollars made in your child's name. Any money earned by investments in the account are tax-deferred.

You can also make tax-free withdrawals from the account—as long as the money is used for your kid's education. Seeing the pattern? All assets in a custodial account are for your child only.

There's also an income limit to contribute to a Coverdell ESA. Your contribution limit is reduced if you make more than $95,000 ($190,000 for joint filers). If your adjusted gross income is $110,000 or more ($220,000 for joint filers), you're ineligible to contribute.

Benefits of a Custodial Account

Some tax advantages
UTMA and UGMA accounts aren't tax deferred. But, there are some benefits. Children under 19 (or 24 for full-time students) who file under their parents' tax return get a reduced tax rate for some of their unearned income. This includes money earned in their custodial account.

It's commonly known as the "kiddie tax." Here's how it works: For 2020, the first $1,100 of your child's investment income is tax-free. The next $1,100 is taxed at the child's bracket of 10%. And anything above $2,200 is taxed at the parent's rate.

You can also contribute up to $15,000 in a UTMA or UGMA account ($30,000 if you're married) without paying the federal gift tax.

Income from Coverdell ESAs are tax deferred. As long as the funds are used for your child's education, you can withdraw the money tax-free.

Flexibility
UTMA and UGMA accounts are very flexible. You can put any kind of asset into a UTMA account, with no contribution, income, or withdrawal limits. The only real stipulation is that you use the money for your child.

Unlike a Coverdell ESA, you can use the funds for anything—not just education.

Easy to open
Opening a custodial account is similar to opening any other bank or investment account. They can be a good way to transfer assets to your kid without having to set up a trust fund. Trust funds are more expensive and more complicated to create.

Drawbacks of a Custodial Account

Reduced financial aid eligibility
One of the biggest downsides to consider is your child's future financial aid eligibility. If there's a lot of money in the custodial account, this could lower the amount of financial aid your kid receives.

Since the money in a custodial account belongs to your child, federal financial aid considers 20% of it available to pay for college. In comparison, money in 529 plans belong to the parent, so only 5.6% of the money is considered available for college.

Account is irrevocable
Once the account is set up in your child's name, there's no changing it. You can't change the beneficiary or reverse contributions to the account. When your child is of age (which is relatively young), your kid is free to use the funds however they choose.

More tax forms to file
Custodial accounts aren't tax sheltered, and they could make tax time a little more annoying. If the account income is over $1,100, you'll have to file a separate tax form for your kid. Contribute more than $15,000? That's another form you'll have to fill out for a gift tax return.

Should I Open a Custodial Account?

Custodial accounts can be a great way to help your kid invest early and save for the future. Still, they're not for everyone.

Before you open a custodial account, make sure you understand how it'll affect your family's finances. If your kid will need lots of financial aid for college, this might not be the right route. Assets in your child's name count against financial aid eligibility.

There's also a chance your child won't be responsible with money at age 18. No parent wants to admit this, but it's something to consider.

Bottom Line

It's always a good idea to save early for your children's future. Custodial accounts can be a great way to teach your youngster about investing and compound interest. Your kid will appreciate the financial lessons as they get older.

But custodial accounts aren't your only option. Remember, you can also save money for your kid in your own savings account.

As with any account, make sure you weigh the pros and cons before you open an account. Taking some time to do research now will set you and your family up for financial success in the future.

Donna Tang is the head of purpose and audience at CreditDonkey, a bank comparison and reviews website. Write to Donna Tang at donna.tang@creditdonkey.com. Follow us on Twitter and Facebook for our latest posts.

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