A custodial account is an investment account that is opened and controlled by an adult, often a parent, on behalf of a minor. The adult, known as the custodian, is responsible for managing the account and making investment decisions for the minor, aka the beneficiary. All of the assets in the custodial account belong solely to the minor, who is eligible to withdraw them in adulthood, which is defined as the age of majority and varies from state to state. Custodial accounts are often used as a way for parents or relatives to set aside money for a child’s future or make it easier to transfer generational wealth.
In this article, we’ll cover:
- How custodial accounts work
- Types of custodial accounts
- Benefits of custodial accounts
- Disadvantages of custodial accounts
How do custodial accounts work?
Custodial accounts allow an adult to open an investment account on behalf of a child and add money and other assets to it. This allows the adult to transfer assets to a minor without the cost and complexity of establishing a formal trust. While parents or other relatives commonly open custodial accounts for children, any adult is allowed to open one for a minor beneficiary.
Once it’s set up, a custodial account works just like any other type of brokerage account. The custodian can add money and manage the investments; they can even take money out of the account as long as the funds are used for the minor’s benefit.
Income from a custodial account is taxable, just like income would be from an adult’s brokerage account. If the account generates taxable income, the custodian is usually responsible for filing a tax return on behalf of the child and paying any taxes owed. The custodian may be able to report a custodial account’s taxable income on their own tax return instead if they meet certain conditions defined by the IRS.
Though the custodian makes the decisions about how to invest the money, the assets in the account belong solely to the beneficiary. The beneficiary cannot withdraw any of the funds until they reach the age of legal adulthood, also called age of majority, which varies from 18 to 25 depending on the state and type of custodial account. At the age of majority, the beneficiary takes control of the assets.
Contribution limits and tax treatment
There are no contribution or income limits for custodial accounts. That said, contributions may trigger a gift tax if they exceed $16,000 for an individual or $32,000 for a married couple.
Contributions are not tax-deductible, and they do not grow tax-free. That said, there can be some tax advantages with a custodial account. Because all the assets in the account are the legal property of the young beneficiary, a portion of the income generated by the account is either untaxed or taxed at the minor’s tax rate, which is nearly always lower than an adult’s. As of 2022, the rules state that the first $1,150 of unearned income is untaxed, the next $1,150 is taxed at the child’s rate, and anything over $2,300 is taxed at the parent’s rate.
Investment options
Custodial accounts can invest in a variety of assets, though the specifics vary by account type. Generally, investment options for custodial accounts include stocks, bonds, cash, and other financial assets. UTMA custodial accounts, discussed below, allow for a wider array of investments.
Types of custodial accounts
There are two main types of custodial accounts: Uniform Gifts to Minors Act (UGMA) accounts and Uniform Transfers to Minors Act (UTMA) accounts. Both types of investment accounts were established by federal laws that states can choose to adopt if they wish. While all states have done so, many have made modifications to the legislation and the specific rules governing the accounts. Custodians will need to understand the details of their specific state’s UGMA and UTMA implementation before making any investment decisions.
Both types of custodial accounts function in the same way. The main difference is the assets that can be held in the accounts.
UGMA account
UGMA accounts can only hold financial products like stocks, bonds, funds, annuities, insurance policies, and cash. A further restriction is that speculative investments are not allowed.
UTMA account
In addition to the financial products allowed by UGMAs, a UTMA account can hold more asset types, such as real estate, artwork, collectibles, intellectual property, patents, and royalties. UTMA also allows some flexibility for gifted assets, like bonds, to reach maturity dates even after the minor comes of age.
Benefits of custodial accounts
Custodial accounts are incredibly flexible and much simpler than establishing a trust fund. There are no withdrawal penalties and no limitations on contributions or income. While any funds the custodian withdraws are required to be used for the benefit of the child, the parameters can be vague; that money might be used for clothing or living expenses, as long as the beneficiary receives the benefit.
- Simpler to establish than a trust fund
- Lots of investment options
- No withdrawal penalties
- No income or contribution limits
- Up to $2,300 taxed at a lower rate
- Flexibility in using funds for child’s benefit
Disadvantages of custodial accounts
One of the main disadvantages of custodial accounts is that because they count as an asset for the beneficiary, they can affect a child’s ability to receive college financial aid and potentially reduce the amount of assistance for which they’re eligible. Additionally, once a beneficiary is established, the account cannot be transferred to another beneficiary. Gifts or deposits made to the account are irrevocable; they become the property of the beneficiary forever.
- Could affect financial aid eligibility
- No change in beneficiaries
- Gifts/deposits are irrevocable
Investing in your family’s future
Whether opening a custodial account is a good idea depends on your circumstances and goals. Many parents, for example, find that a custodial account can be an effective way to invest money on their child’s behalf to get a head start on saving for things like college. Some people also see a benefit in passing down wealth without the hassles of creating a trust fund. As you explore investment opportunities for your family, you may find that a custodial account makes sense for you. It’s never too early to start saving, and you open a custodial account to get a head start on securing your child’s future.
Custodial account FAQ
1. Are there different types of custodial accounts?
Yes, there are two types of custodial accounts; depending on the state you live in, the account may fall under one of two legal frameworks:
- Uniform Gifts to Minors Act (UGMA), which can contain only financial assets, like stocks, bonds, and insurance products
- Uniform Transfers to Minors Act (UTMA), which allows investments in more types of assets, like real estate
In most states, only one type of custodial account is allowed. Stash offers custodial accounts of both types, so you can choose whichever is allowed by applicable law in your state.
2. Who can open a custodial account?
Any adult can open a custodial account for a child. It’s common for parents to open custodial accounts for their children, but any adult–grandparent, aunt, uncle, godparent, chosen family member, and so on—can open one. To be clear, the adult who opens the account is the custodian of the account, not necessarily the child’s custodian.
The custodian will need some information to open the account, including the child’s full name, date of birth, and social security number.
3. Do custodial accounts impact taxes or financial aid?
They might. If you plan to open a custodial account, you may want to learn more about the tax implications and the potential impact on the child’s ability to get financial aid for college. Learn how you can best save for college without impacting financial aid.
The post What Is a Custodial Account? appeared first on Stash Learn.
https://www.stash.com/learn/what-are-custodial-accounts/
#financialfreedom #money #entrepreneur #business #finance #investing #financialliteracy #success #investment #wealth #motivation #financialindependence #passiveincome #personalfinance #realestate #stockmarket #debtfree #entrepreneurship #invest #bitcoin #creditrepair #debtfreecommunity #investor #trading #workfromhome #stocks #credit #financialeducation #bhfyp