A lesser known financial product, a custodial account can actually help you invest in your child’s future. It can help you have some money for your child that can also teach them how to learn how to budget. Continue reading to learn more about a custodial account and how it works.
What is a Custodial Account?
Technically speaking, a custodial account is any type of financial account opened by one person on behalf of a beneficiary. In this post, we will talk about the most common kinds of custodial accounts. More specifically, a bank account or brokerage account opened by a parent for their child.
Custodial accounts are great tools to help give your kids a head start on investing or to give them hands-on experience with saving money. You will have the ability to check on the account as the custodian. Until your kid reaches adulthood, all transactions need to be approved by you. Also, you will be able to withdraw money, but only if it used for your child or their education.
Once your child turns 18 or 21, they get full control of their account to do whatever they want with it. You can also get some tax benefits. However, there are some drawbacks to these types of accounts too. Check out the pros and cons of custodial accounts 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:
| UTMA | UGMA | Coverdell ESA | |
| Assets used for | Anything | Anything | Education only |
| Types of assets | Any asset, including property | Cash, securities, annuities, insurance policies | Cash |
| Contribution limits | None | None | $2,000/year |
Uniform Transfer To Minors Act (UTMA) Account
UTMA accounts are pretty flexible if you need to transfer any type of asset to your kid. These accounts can hold cash, stocks, real estate, artwork, and more. It is 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. However, if you live in South Carolina or Vermont, you won’t be able to take advantage of these accounts. These are the only states that don’t allow UTMA accounts. Find out which type you can use instead of this one.
Uniform Gift To Minors Act (UGMA) Account
UGMA accounts are actually quite similar to UTMA accounts. One of the biggest differences between the accounts 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 now contribution limts or income limits, and custodians can deposit and withdraw money as they need as long as it is in the child’s benefit.
Coverdell Education Savings Account (ESA)
This third type of account is much narrower than the other two. Coverdell ESAs are meant for education savings only. It can be a good alternative to a 529 plan. This account lets 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. All assets in a custodial account are for your child only. There is 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 won’t be eligible to contribute.
Benefits of a Custodial Account
There are some tax advantages to get from these types of accounts. UTMA and UGMA accounts aren’t tax deferred. However, 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.
This is mainly known as a “kiddie tax.” Here is 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.
Additionally, you can contribute up to $15,000 in a UTMA or UGMA account ($30,000 if you’re married) without paying the federal gift tax. Income that comes from the Coverdell ESAs are tax deferred. As long as the funds are used for your child’s education, you can withdraw the money tax-free.
On top of that, you gain some flexibility with these accounts. You can put any kind of asset into your UTMA account, with not 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.
These accounts are easy to open just like other bank or investment accounts. They can be a good way to transfer assets to your child without having to set up a trust fund. Trust funds are more expensive and can be more complicated to create.
Drawbacks of a Custodial Account
One of the major downsides of opening one of these types of accounts is to consider your child’s future financial aid eligibility. If there is 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 is for your child, federal financial aid considers 20% of it available to pay for college. In comparison, the 529 plan belongs to the parent, so only 5.6% of the money is considered available for your child’s college.
Once the account is set up in your child’s name, there is no changing it. You cannot change the beneficiary or reverse contributions to the account. When your child is of age your, they can use the funds however they choose.
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 will have to file a separate tax form for your kid. If you wanna contribute more than $15,000 then that is another form you will have to fill out for a gift tax return.
Should I Open a Custodial Account?
Custodial accounts are a great way to help your kid invest early and save for their future. Still, it is not for everyone. Before considering open a custodial account, make sure you understand how it will affect your family’s finances. If your kid will need financial aid for college, they will get less if you open one of these accounts.
Assets in your child’s name will work against financial aid eligibility. There is also a chance your child won’t be responsible with money at 18 years old.
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Bottom Line
Naturally, it is always a good idea to start building up some money for your child’s future. Custodial accounts are great tools in doing just that. On top of that, it can help teach your child about investing and compound interest. For more post like this, check out our list of bank guides and bank account promotions.
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