What is a Custodial Account?

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Definition:

A custodial account is a type of savings or investment account that an adult can open for a minor, to be turned over to the beneficiary when they reach a certain age, usually determined by state law.

🤔 Understanding a custodial account

There might be situations where parents or grandparents want to begin saving and investing for the future on behalf of a child, but the beneficiary isn’t old enough to control the account. A custodial account is a way for adults to set aside money that the child can use later on. Even though an adult sets up and controls a custodial account, the money belongs to the minor as soon as it enters the account. The adult who opens the account can’t take it back out. When the beneficiary reaches a certain age (either 18 or 21, depending on the state) they get control of the account. Someone might set up a custodial account to save for a child’s college education, start saving for their retirement, or even just set aside money as a gift for when they reach adulthood.

Example

Suppose Anna wants to set aside some money for each of her grandchildren. She’d like to arrange for each of the grandchildren to receive a large gift from her on their 18th birthday. Anna decides to set up custodial accounts with cash and investments so the money can continue to grow even more. She sets up a custodial account in each of her grandchildren’s names and begins making regular contributions. Over the years, the money keeps growing. On each of the kids’ 18th birthday, they get control of the account. They can keep it as an investment account, or take the money out to enjoy it.

Takeaway

A custodial account is like house-sitting for a friend while they’re on vacation…

Imagine that a friend of yours is going on vacation and asks you to stay at their house while they’re gone. Once they get back from the trip, you’ll have to hand the keys back. A custodial account is similar, in that you have to hand over control of the account when the minor reaches 18. The difference is that while your friend paid for the house, the adult who opened the account put the money in on behalf of the kid.

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What is a custodial account?

A custodial account is a tax-advantaged account that adults can open to pass money and other assets along to the children in their lives when they reach adulthood. Unlike a traditional savings account that someone might open at their local bank, custodial accounts can hold a lot more than cash — You can contribute cash, investments, insurance policies, and often physical assets such as real estate. Once the child whose name is on the account becomes an adult (the exact age varies from state to state) they gain control of the account.

What are the types of custodial accounts?

There are two different types of custodial accounts for minors. The two plans are mostly the same — The major difference comes down to what type of assets you can contribute. The state in which someone lives will determine which type of account they can open.

  • Uniform Gift to Minors Act (UGMA) Account: A UGMA account is a type of custodial account where the account holder can contribute cash, securities (financial items you can invest in, such as stocks and bonds), and insurance policies.
  • Uniform Transfer to Minors Act (UTMA) Account: A UTMA account is a type of custodial account where the account holder can contribute any type of investment. Like the UGMA accounts, owners can contribute cash and investments. They can also put physical assets such as real estate into these accounts.

How does a custodial account work?

A custodial account is a type of savings or investment account that an adult (often a parent or grandparent, but can also be a nonrelative) opens for a child. The adult then transfers assets such as cash and investments into the account. Once the money goes into the account, it belongs to the child. The adult can continue to contribute more assets over the years. Once the child reaches age 18 or 21 (depending on the state they live in), they gain control over the account. They can leave the money in the account or choose to withdraw it.

Who owns a custodial account?

When it comes down to who owns a custodial account, it depends on how you look at it. Once assets go into a custodial account, they belong to the child whose name is on the account. The adult who opened the account cannot take any money or other assets out of the account unless it is used for the benefit of the child beyond normal living expenses.

But the child doesn’t have control of the account until they reach age 18 or 21 (depending on the state they live in). They technically own all of the assets within the account. But the adult who opened the account has control of it until the child reaches the required age.

How are custodial accounts taxed?

The tax rate on income from a custodial account depends on its level of income, and the normal tax rate of both the child who is the beneficiary of the account and the adult who opens the account. For custodial account beneficiaries that are under the age of 19 or, or under the age of 24 and a full-time student, the tax rates are as follows:

  • There are no taxes paid on the first $1,050 of unearned income.
  • The next $1,050 will be taxed at the child’s tax rate.
  • Any amount of income over $2,100 will be taxed at the rate of the adult who controls the account.

How do you get money out of a custodial account?

Once money goes into a custodial account, it belongs to the child whose name is on the account. The adult who set up the account can’t get that money back. But that doesn’t mean they can’t take money out at all. The account custodian can withdraw money to cover certain expenses for the child.

Custodial accounts legally cannot be used to pay for daily living expenses that the parents would normally pay for. However, there are some expenses, for the benefit of the child, for which the money can be used. You may want to talk to a financial advisor or attorney before spending the money in a custodial account. Improperly spending the money could result in legal penalties, including but not limited to fully replacing the money in the account.

Once the child reaches the necessary age and gains control of the account, they’re free to withdraw money as they like or sell off any of the investments in the account. They can also choose to leave it in the account.

What is the difference between a custodial account and a 529?

A custodial account is a type of savings and investment account that adults can open to pass money and assets along to a child when they reach adulthood.

A 529 plan is another type of tax-advantaged plan that adults can set up to save for the future of children in their lives. The difference is that while custodial accounts hold assets to eventually pass along to the child, 529 plans are specifically meant to save for education expenses.

A 529 plan is a tax-advantaged account that allows adults to contribute money on behalf of a child. They can invest the funds in the account to help them grow. Eventually, they can use that money to pay for tuition, fees, room, and board for their kids during college. Anyone who uses the funds in their 529 plan for expenses not related to education may end up paying fees on that money.

Are custodial accounts a good idea?

Under certain circumstances, parents and grandparents might consider using a custodial account to pass along money to kids for purposes of paying for college or receiving an inheritance when they reach adulthood.

These plans have certain advantages over others. There are no limits to the amount that someone can contribute to or withdraw from a custodial account. There are also no requirements as to what the child must spend the money on in the future, as there are with 529 college savings plans.

But there are downsides to these plans as well. The tax advantages aren’t as strong as 529 plans, which come with tax-free withdrawals as long as you spend the money on education expenses. The lack of limits on custodial accounts might also be a disadvantage. You can’t stop a child from spending the money on whatever they want once they reach the required age.

What should parents and grandparents know about custodial accounts?

While custodial accounts can be an effective way of putting away money for your children’s future, there are some tax and legal implications that parents and grandparents may want to consider before opening an account:

  • You may have to file tax returns and pay taxes on behalf of your child for the custodial account’s earnings. In general, if the income exceeds a certain amount, you’ll have to file a tax return and pay taxes at an increased rate. The tax rates for custodial accounts match those for trusts and estates, and are greater than the normal capital gains tax rate. You may also have to file a gift tax return while you’re at it.
  • Once the money goes into the account, the account owner (meaning the adult that set it up) no longer has full access to the money. Any money that comes out of the account must be used to pay for expenses though not daily living expenses — for the child whose name is on the account. Because the account is tied to a particular child, you also can’t use the money to cover expenses for your other children.
  • Depending on your state’s laws, the custodial account beneficiary gains ownership and full control of the account at age 18 or 21. The adult who set up the account no longer has any control over it. Individuals may want to rethink this type of account if they question whether their kids will be able to make responsible financial decisions.
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