What is a custodial account?
Custodial accounts refer to savings account or investment accounts at banks, mutual fund companies or financial institutions where a parent or guardian is in control of the account despite the account being owned by the minor (someone under 18 or 21 years of age). Custodial accounts are commonly used by parents to begin the savings or wealth building process for their children.
Custodial accounts have some distinct characteristics. For instance, the money and assets in the custodial accounts are owned by the minor whom is named on the account. The parent or guardian can’t take the money back once it’s in the account. Moreover, once the minor is of age based on state rules, the assets are fully in his or her control and he or she can do whatever they want with the assets.
Why use a custodial account? Why not just give some money to your kids when they come of age? You certainly can do so, but there are some advantages of using a custodial account. First, there are some tax advantages of using custodial accounts. While the contributions are not tax-deferred (such as an IRA) and the gains aren’t tax-free when used on things like education (such as is the case for a 529), there are some tax reasons to use the accounts. Because the minor owns the account, the IRS considers the earnings in the account as earnings for the minor, and are thus taxed at the child’s tax rate (likely lower than the parent or guardian’s tax rate). Moreover, the first $1,050 of income each year is tax free, and the next $1,050 is taxed at the child’s tax rate of 10%. Lastly, the parent or guardian can contribute significant amounts of money (e.g. $15,000-$30,000) into such an account without incurring gift tax.
But the reasons aren’t just mathematical reasons. Custodial accounts provide a very unique opportunity to teach your children about saving and investing. Kids aren’t concerned with an account being called a custodial account. All they know is that they have their own stocks account, and my kids have found it very interesting. By having some “skin in the game,” it has made my kids much more interested in learning about stocks. I have paired the process with some educational reading material and have had them do some simple research on the companies that they want to invest in. By having real money in a custodial account, it has launched an entirely new learning adventure for them. One that will pay off greatly I hope in forming lifelong investors.
Let’s start digging into custodial accounts by first looking at the types of custodial accounts available.
UTMA vs. UGMA
UTMA and UGMA accounts are typically referenced as the same thing. The terms are often used interchangeably. However, UTMA and UGMA are types of custodial accounts, and there are some minor differences between them.
The main difference is the type of assets that can be added to the account. Generally, UGMA accounts are limited to financial assets such as stocks, bonds, cash, etc. UTMA accounts are a bit more flexible in that they allow financial assets such as stocks, bonds and cash, but also other types of assets such as real estate, etc.
Additionally, while all U.S. states allow UGMA accounts, a handful of states do not allow UTMA accounts (Vermont and South Carolina as of writing).
When opening a custodial account, be sure to understand if the account is a UTMA or an UGMA account. If you’re using a major brokerage such as Charles Schwab, then typically this will all be handled for you. But it’s still worth understanding and knowing how your account is classified. Moreover, you’ll want to know the age when your child is going to take over
Age of majority
Age of majority is a term used in many contexts, but also the context of custodial accounts. Age of majority refers to the threshold of adulthood as recognized by law when a minor becomes an adult and gains legal control over himself, decisions and assets. Specifically related to custodial accounts, age of majority refers to when the minor takes control of the account and the assets in the account.
When the minor reaches the age of majority, he can do whatever he wishes with the assets in the account. The person now in control can liquidate the assets, request a check and gamble it away in a casino if he or she desires.
The age of majority for custodial accounts varies by state. Be sure to know what age your child will take over a custodial account, and if your state allows you to specify anything in particular regarding this process.
Custodial accounts vs 529
One of the most common questions around custodial accounts comes around whether you should open a custodial account for your child or a 529. Frankly, both are great vehicles for your kids and if you have the means to contribute to both, I’d strongly recommend it. There are some key differences between the accounts, so let’s break those down.
The key differences between a custodial account and a 529 revolve around who owns the assets and how the assets are taxed when withdrawn. With a 529 plan, the parent owns the plan. The parent can modify it and can change the beneficiary. If, for instance, your child is doing quite well in school and gets scholarships and doesn’t need the money in a 529, then you can change the beneficiary and that particular child will no longer be associated with that 529. The parent is in complete control.
With a custodial account, however, the minor owns the assets. Once money has been contributed to the account, it cannot be reversed and it cannot be changed to a different child.
On the taxation front, the 529 is wonderful in that the proceeds of the account can be withdrawn and used for educational expenses without paying taxes. A 529 is almost entirely associated with funding a kid’s college expenses (or other education expenses) whereas a custodial account is more of a general savings or wealth building tool.
Additionally, while parents can avoid gift taxes by contributing money into both custodial accounts and 529 accounts, there is no “super” contribution possible with a custodial account like there is with a 529 account. With a 529 account, a parent can essentially contribute five years worth of maximum contributions without incurring gift tax all at once. This is a way to let parents get a big chunk of money into the account immediately and start growing. You can’t do this with a custodial account.
Custodial accounts vs. trust fund
While we often compare custodial accounts to 529s, another common comparison is a custodial account compared to a trust fund.
A trust fund is an estate planning mechanism often used to facilitate the transfer of assets to children, grandchildren or others. The primary benefit of utilizing a trust for this transfer is that assets avoid probate upon the death of the grantor, and thus, assets can be distributed quickly and seamlessly to the appropriate individuals. Trusts are a very complex topic and doing the topic justice is beyond the scope of this article. It can be worthwhile to talk to legal and accounting professionals to discuss trusts if you think it makes sense for your situation.
Why bring up trusts? Well, custodial accounts are sometimes considered an easy and inexpensive alternative to a trust if we’re considering a very narrow purpose here. To be fair, the purpose of a trust is not truly the same as the purpose of a custodial account. Custodial accounts are mostly used for saving money for children whereas a trust is used for saving or transferring assets in the event of death.
If you’re looking to protect wealth in the event of death and ensure assets are protected and distributed according to your wishes, a trust is definitely a must. And even if you have a trust setup properly, you can also utilize custodial accounts to begin saving money for your kids or grandkids.
Advantages of a custodial account
We’ve discussed many of the advantages of a custodial account, but let’s recap them here so you can see them at a glance:
- Custodial accounts are a great way to introduce your children to savings and investing.
- Custodial accounts are great tools for launching the wealth building process for your kids.
- By contributing assets into your kid’s name via a custodial account, you’re reducing the taxation on such money had you kept it in your own account. This is because the first $1,050 in gains for a minor is tax free, and the second $1,050 is simply at 10%. Further gains is at the child’s tax rate (still likely lower than yours).
- Contributing money into a custodial account does not incur gift tax.
Potential disadvantages of a custodial account
Are there any disadvantages of a custodial account? I’m not sure I”d call them disadvantages, but here are some things worth consideration:
- Since the assets in a custodial account are owned by and in the name of the minor, these assets could have a negative impact on financial aid that a college is willing to provide.
- Custodial accounts do not have the benefits of a 529 account in that withdrawals can be used tax free on educational expenses.
How much can you save for your kids?
Now for some fun… it’s quite amazing how much money your kids can amass by some simple contributions into a custodial account at an early age. Let’s look at some examples.
Example #1: Save $100/month for 20 years, then stop
In this example, the parent starts saving $100 per month immediately upon having a child and continues this for 20 years (240 months). Then, the contributions stop.
We’re assuming a 8% rate of return compounded monthly.
The balance after 20 years of contributing $100 per year is just shy of $57,000.
The amazing thing is what happens next. With zero further contributions, the money continues to grow. At age 65, this balance has now reached $1,816,000 and nobody has put money towards this balance in 45 years! Here’s a chart of how this looks:
As you can see, similar to any compounding example, the most growth happens later in the time duration. And as we mentioned, we aren’t even contributing money into this balance anymore. All the growth comes from investment gains.
If your child just leaves the money alone and lets it grow, it grows into a substantial sum. Obviously, if your child is successful and financial responsible, they will likely add to the net worth with other investments. But regardless, this is an incredible way to jumpstart the wealth of your kids.
Example #2: Save $250/month for 20 years, then stop
In this example, the parent starts saving $250 per month immediately upon having a child and continues this for 20 years (240 months). Then, the contributions stop.
We’re assuming a 8% annual return compounded monthly.
The balance after 20 years of contributing $100 per year is just shy of $142,000.
…and just like the previous example, the balance grows to extraordinary numbers even without further contributions. At age 65, the balance is over $4.5 million.
Here is the chart:
Common & not-so-common questions
What happens if the parent dies before the minor takes over the custodial account?
There can be a range of variables here to determine how this event is handled. Some custodial accounts have successor custodians named upon creation of the account. If so, then this is handled pretty smoothly. If no successor is named, depending on the state, the child may be able to name the successor custodian. If that isn’t possible, again depending on the state, the new guardian might be automatically named the new custodian. Either way, you should work through an attorney on this specific issue should you be dealing with it. Most importantly, it should be known that the assets in the account are not going to be included in the estate of the custodian. The assets belong to the minor.
What happens if the minor dies before taking over the custodial account?
In this event, the assets in the custodial account are considered part of the minor’s estate and distributed according to state law.
Does my kid have to start filing a tax return if he/she has a custodial account?
Yes, it is possible. Typically if the income from the account exceeds $1,100 (in 2019), a 1040 form is usually supplied and needs to be filed for your child. Some tax might be owed in this case.
What size account would lead to income over $1,100? Well, for a simple example, if an account generates 2.5% in dividend and/or interest income, the account would need to have a value of approximately $44,000 in order to generate $1,110. So, based on the size of your child’s custodial accounts, you can gauge whether or not you’re close to owing tax.
I’ve changed my mind. I want to take the money back out of the custodial account.
Can’t do it. Once you’ve put money in, you can’t take it out. That money now belongs to the minor.
Is a custodial account a good way to jumpstart my kid’s savings?
Absolutely. Consider pairing with a 529 account so you can gain the tax advantages of saving and paying for college, but for general savings and wealth building, a custodial account is a great tool!
Is a custodial account a good way to teach my kid about investing?
Absolutely. I’ve found that a custodial account is more useful than, say, a 529 account for teaching about investing. The 529 account is a group of index funds that doesn’t exactly lead to my kids being interested. A custodial account with stocks such as Apple or Netflix (companies my kids are quite familiar with!)? That piques their interest.
Do I have to pay gift tax on the money I contribute to a custodial account?
If you contribute more than $15,000 (or $30,000) to a minor, you might incur a gift tax.
When will my child take over control of the custodial account?
This can vary by state. Typically it is 18 or 21. Some states have some unique characteristics where you can specify even later – for instance, in Florida, you can setup a custodial account to where the minor takes over as late as age 25.
What is the minimum amount of money I can start a custodial account with?
This will depend on the brokerage you’re using, but account minimums have become super low, even as low as $1 in recent years with the increased competition over lower account minimums and fees.
What is the maximum amount of money I can contribute to a custodial account?
Typically, people max out on an annual basis based on the gift tax parameters which is $15,000 per year or $30,000 per couple.
Does a custodial account makes sense for me?
“I want to save money for my kids college and education expenses”
You should be considering a 529 account first and foremost if paying for your kid’s college expenses is the priority. Above and beyond that, a custodial account can be a great tool for additional savings and wealth building.
“I want to transfer significant amounts of wealth to my children.”
You are likely exceeding what a custodial account is aimed for. If you’re looking to transfer significant wealth, then you need to be engaging an attorney and working through a proper estate plan. Likely a trust is going to make more sense than a custodial account for this situation.