Custodial Investment Accounts Explained

Custodial accounts allow a custodian and account manager to manage and gift assets for the benefit of a minor. Since minors are not permitted to open financial accounts in their own name, a custodial account allows an adult to help a minor get a jump start on investing and saving.

Parents will often set up a custodial account for their children but almost anyone can contribute into the account providing a great level of flexibility. The assets or gifts that are placed into the account are irrevocable meaning that they cannot be changed or reversed.

Once the child reaches legal age the account will transfer to the minor and be reestablished in their name. The legal age that initiates this process will depend on the state as each state's laws vary but it is typically between 18 and 25 years old.

UGMA got its acronym from the Uniform Gift to Minors Act and can be established in all 50 states. This type of custodial account allows for cash, stocks, bonds, mutual funds and insurance policies to be placed into the account for the benefit of the minor.

UTMA got its acronym from the Uniform Transfer to Minors Act which further expanded upon the rules set by the UGMA. UTMAs allow for almost any asset to be transferred into the account including real estate, whereas UGMAs limit the types of assets allowed to be in the account. UTMAs have been accepted by all 50 states except South Carolina and Vermont.

Custodial accounts do not limit the amount of money that can be placed in the account. Almost anyone can make a gift into a custodial account and there are no income limitations that restrict the ability to contribute that occur in other financial accounts like Roth IRAs.

Although anyone can contribute to the account, contributors should be aware of the gift tax exclusion threshold. For 2024, an individual can give $18,000 per year or $36,000 for a married couple without incurring a gift tax. A contribution above this limit is allowed into a custodial account, but may require the donor to pay a tax.

Custodial accounts do not provide a tax deferred or tax free shelter like other financial accounts do. The income generated from the account via either bond interest and dividends or a capital gain from selling an asset will be taxable.

The minor is responsible for paying the taxes on any income generated from the assets in the account as the minor technically owns the assets even if they do not control the account. There are some special tax rules that do apply to these accounts.

For 2024, the first $1,300 of income generated in the account is tax exempt. The next $1,300 is taxed at the child's tax rate which is usually quite low as most minors do not earn an income. Beyond these limits, any income may be taxed at the parents tax rate.

For example, say a child earned $3,000 in income from their custodial account. The first $1,300 is exempt. Say that the child's tax rate was 10% meaning that the child would owe $130 on the next $1,300. If the parents tax rate were 30%, the child may owe $120 in taxes. The child would be left with $2,750 in this example after taxes were paid.

As previously noted, assets or gifts placed into a custodial account are done so on an irrevocable basis meaning that they cannot be changed or reversed. Essentially, once the assets are in the account they are held until the minor comes of age.

Due to this, assets must be managed with the best interest of the minor in mind. If a parent were to open a custodial account for their child, they may take withdrawals at any time but the withdrawals must be of benefit to the minor. Once the account is transferred to the minor, the former minor takes full control of the account.

The primary benefit of a custodial account is their flexibility. They are relatively easy to set up, do not have contribution limits, and allow easy access to the funds inside of the account. Additionally, there are no requirements to pull money out of the account at any time whereas other financial accounts such as 401k plans force you to pull funds out in retirement through RMDs.

Due to this flexibility, parents, grandparents, and friends can help a minor get a jump start on almost any financial goal. This could include paying for educational costs, getting a jump start on retirement, helping fund the purchase of a home and more.  

Although the flexibility of custodial accounts can be of great benefit, it can also be a double edged sword. Depending on state laws, a minor may take full control of the account when they are 18 years old. If the minor that takes control of the account does not have the proper financial skills and discipline to manage the assets, a custodial account may do more harm than good.

For example, say that a grandparent wanted to help their grandchild get ahead with home ownership. The grandparents set up a custodial account and consistently contributed to it with the intention that their grandchild would use the funds for a down payment on a home.

However, if there was a reasonable amount of money in the account, the minor may be tempted to use those funds for something "fun" as opposed to something responsible. Remember, once the account transfers the minor has full control of the funds.

In this example, the grandparents would not be able to enforce that their grandchild use the funds for their intended use. The grandparents would have to hope that the minor would simply agree with their request. Beyond the risk of flexibility, a custodial account may restrict the minor's ability to receive financial aid, grants or community help when the minor applies for college as the assets are considered the minors.

A 529 plan is a savings and investment account designed to help pay for educational expenses. A 529 plan offers tax deferred growth, and withdrawals are tax free as long as they are used for educational expenses. These accounts are administered by the 50 states so the rules can vary state to state.

If a parent, grandparent or other custodian wanted to set up a custodial account to help their child save for their education, but were worried their minor may not be responsible with the funds, a 529 plan may be a better option.

Even though the funds in a 529 plan are still set up to benefit the minor, the person who set up the account (most likely a parent) can retain more control over the account and ensure that the funds are used for their intended use.  

A trust is a legal arrangement involving three parties to ensure that a person's assets are distributed to their desired beneficiaries in a manner that the individual desires. The three parties of a trust include the grantor, trustee, and beneficiary. The grantor of the trust is the creator of the trust.

The grantor puts a trustee in charge of managing and distributing the assets of the trust to the grantor's beneficiaries. The trustee has legal control of the assets within the trust, but must manage them in the best interest of the beneficiary.

Trusts are created by attorneys who draft a document called the trust agreement which dictate the terms of the trust. Trusts primarily exist as an estate planning tool and can help ensure a smooth transition process when the grantor passes his or her assets to their respective beneficiaries.

Trusts are more complex and often much more expensive to set up than a custodial account as they often require the help of an attorney. However, trusts are a way to ensure that a minor uses funds for their intended use. The terms of the trust can dictate when and how a beneficiary can use their assets in great detail not available through a custodial account.  

The bottom line is that custodial accounts allow a custodian and account manager to manage and gift assets for the benefit of a minor. Custodial accounts can help a minor get a jump start on a range of financial goals due to the flexibility offered by the accounts.

Although custodial accounts may be a viable solution, it is important to consider all options before concluding a custodial account is the best option. A financial advisor can help with this decision if needed.