What Is a Custodial Account?
Custodial accounts are generally savings accounts at banks, mutual fund companies or brokerages that are usually controlled by one person on behalf of one other person. A custodial account is typically controlled by an adult for a minor, a person who is not yet 18 or 21 years old (the minimum age in most states of the US). Transactions involving buying and selling securities in the account may occur only with the custodian’s consent.
Key Takeaways
A custodial account is most often a savings account with an adult proxy for a minor.
Custodial accounts have enormous flexibility, with no income or contribution limits or withdrawal penalties.
Custodial accounts don’t require distributions at any point.
The funds are deposited into a custodial account which cannot be adjusted or reversed. Gifts are irrevocable.
The inventory of its ownerships transfers finally and irrevocably to the infant’s guardianship upon the infant’s coming of age, in accordance with the laws of the state in which the infant resides.
More generally, a custodial account can refer to an account of any type held on behalf of a beneficiary by a party subject to a fiduciary duty – for example, an employer-sponsored savings account that would, for eligible workers, be handled by a plan administrator. A fiduciary is obligated both ethically and legally to act in the best interest of another.
Each state has requirements ranging from when someone can legally be an adult to who can be named as a custodian and alternate custodian.
How a Custodial Account Works
After it’s set up, a custodial account acts like a regular account at a bank or brokerage. The custodian – typically a guardian or investment adviser – decides the investments. The account trustee – or other parties – can keep adding to the fund.
As noted earlier, some custodial accounts offer the ability to invest in assets other than bank accounts and brokerage accounts; there are even some custodial accounts that allow the manager to invest via cryptocurrency. In general, financial institutions do not permit the account’s owner to trade on margin from the custodial account or engage in certain types of highly-speculative investments called futures or derivatives.
Then the account is turned over to the named beneficiary from the custodian when the minor reaches the age of majority in his state. After that, the beneficiary can lay legal claim to the funds and their control. If the minor also passes away before the age of majority, the account is then part of the minor’s estate.
Types of Custodial Accounts
Two types of custodial accounts exist: Uniform Transfers to Minors Act (UTMA), which exists in all states but Vermont and South Carolina, and the Uniform Gift to Minors Act (UGMA), which exists in all 50 states.
An UTMA account can hold almost any kind of asset, including real estate, intellectual property and works of art; an UGMA account is restricted to financial assets, such as cash, securities (stocks, bonds, mutual funds), annuities and insurance policies.
In whichever kind of custodial account you open, you open the account in the minor’s name and designate the custodian – typically the minor’s parent or guardian. Minimum opening balances, contributions and interest rates depend on the account provider.
Advantages and Disadvantages of Custodial Accounts
There are advantages such as tax breaks, and disadvantages such as the fact that a noncustodial account might unduly restrict the amount of financial aid a college is willing to give your child (as this counts as a minor’s asset).
Advantages of Custodial Accounts
But custodial accounts come with a significant upside. For starters, custodial accounts are very flexible. There are no requirements regarding the custodian’s financial status to make contributions (like being eligible to contribute to a Roth IRA based on income). There are no contribution limits. There are no requirements regarding taking distributions at any point in time. There are no penalties for withdrawals.
Although all disbursed money must specify that it is for the minor’s ‘benefit’, the requirement is more nebulous than for a college savings plan, and doesn’t need to be devoted to educational expenses of any kind. On the discretion of the custodian, the money can pay for everything from lodging to clothing, so long as the beneficiary receives a benefit.
A custodial account is easier to set up and less expensive to administer than a trust The basic purpose behind all of the legislation governing UGMAs and UTMAs is to allow adults to convey property to minors without setting up a special trust, which is typically required to allow a minor to own property.
Tax Advantages
Because custodial accounts aren’t tax-deferred like IRAs, the child’s earnings are taxed at the child’s own tax rate, up to a point. (The IRS treats the child as the ‘owner’ of the account.) Still, there are some tax breaks, technically called the kiddie tax. Every minor under the age of 19 – or longer, if the child is a full-time student – who files as a dependent on a parent’s tax return has ‘unearned income’ that’s taxed at a lower rate. Depending on the child’s age, the income cutoff generally ranges from $2,100 to $9,900. A child has unearned income if he or she makes money from investments, such as dividends or interest.
On the unearned side, the first $1,300 of any nonwage income is tax free, while the next $1,300 is taxed at the child’s marginal tax rate. Everything over that amount could bump up into the parent’s. Then the minor turns the magic age of majority in the state where she files and can file her own tax return for the account. Upon reaching that age, all of the earnings for that year will be taxed at her marginal tax rate at the filing age.
In addition, an individual is allowed to give up to $18,000 for the tax year of 2024 without incurring federal gift tax.
Disadvantages of Custodial Accounts
So having a minor be the sole owner of the custodial account comes with an Achilles’ heel: because the holdings are considered an asset, any child applying to college might end up with lowered financial aid eligibility or lost access to other forms of government or community aid.
Any funds contributed to the account, or otherwise gifted, are irrevocable – ie, cannot be revoked or changed or changed back. All the account’s assets are irrevocably passed to the minor at the age of majority. On the other hand, a number of the most popular types of college savings plans – including 529 accounts – give the parents control over the money.
Custodial accounts aren’t heavily tax-sheltered like some plans Parents who don’t want to take a tax bite can transfer education funds out of custodial accounts to a qualified 529 plan, if one exists. To do so, however, the custodian must sell off any non-cash investments in the account.
Further, the beneficiary of the custodial account cannot be changed. Meanwhile, the beneficiary of a 529 college plan can be changed (with limitations). A custodial account is held in the name of the minor. Since the account is considered irrevocable, the beneficiary of the account cannot change and no gifts or contributions into the account cannot be rolled back.
Pros & Cons of a Custodial Account
Pros
Easy to establish and manage
Free from income, contribution, or withdrawal limits
Can invest in a variety of assets
Cons
Less tax-advantaged than some comparable accounts like 529s
Can hurt child’s financial aid prospects
Irrevocably passes to child upon their reaching majority age
Examples of a Custodial Account
Nearly all brokerage houses, both online or brick-and-mortar, have custodial accounts, whose names and terms can sound like those of regular (that is, non-tax-advantaged) accounts for individuals.
For instance, at Merrill Edge–the online broker associated with that old-line firm Merrill Lynch–an UGMA/UTMA custodial account can be easily established online, and funds can be transferred from a connected paper checking or savings account at a parent company, Bank of America, with no account fees and no minimum investment.
You can also open custodial deposit and checking accounts at most bank branches.
Frequently Asked Questions (FAQs)
Can You Withdraw Money From a Custodial Account?
Yes, money can be withdrawn from custodial accounts as long as it is ‘for the benefit of the minor’, a phrase that in practice comes to cover educational expenses, though these are not technically mandatory.
What Do You Do With a Custodial Account When Your Child Turns 18?
The account ‘belongs’ to the child at the age of majority (18 or 21, depending on state laws).
How Do I Get a Custodial Account?
You can get an account by finding somebody over the age of 18 or 21, depending on what state you are in, who will open a custodial account that you can use to buy and sell cryptocurrencies until you are of age, at which point it just gets handed off to you.
How Is a Custodial Account Taxed?
Children are usually reported on their parent’s tax return. Any unearned income, interest and dividends over the $2,600 threshold for UGMA or UTMA custodial accounts will be taxed at the parent’s rate, according to the IRS.
The Bottom Line
You can create a custodial account by opening a savings or brokerage account for a child in your name and with your money. The account holder, usually an adult, is responsible for keeping the account and making investment decisions, and for deciding how the money is spent, as long as it is for the benefit of the child. There are some tax breaks to a custodial account, but they also have some risks – for example, the mere existence of the account can mean that the child gets less financial aid for college. Think about the pros and cons before opening a custodial account.
Retirement Security Rule: What It Is and What It Means for Investors
The rule, called the Retirement Security Rule (or the fiduciary rule) and published under a final version in April 2016, was tailored to protect investors from conflicts of interest that arise when an investor (who adds money to her retirement savings) receives investment advice from a financial adviser.
The rule, set out by the US Department of Labor (DOL), will come into force on September 23, 2024 and relates to changes implemented by the department. In addition, the timings for some of these conditions will be delayed until 2025.
The rule applies to anyone who saves or invests for retirement, and uses an advisor, that advisor is subject to the higher fiduciary ‘best advice’ standard, not the lower standard of merely ‘suitable advice’. That’s the designation under the Employee Retirement Income Security Act (ERISA) that markets the retirement product and the trusted advisor. ERISA advisors, via the new fiduciary rule, restrict the product and services the advisor can sell to retirement-saving clients.
But the rule will not apply to custodial accounts. ‘The Department of Labor [which enforces ERISA rules],’ says Korenman at T Rowe Price, ‘doesn’t have jurisdiction over UGMA or UTMA accounts, so [the new] Retirement Security Rule does not apply to custodial accounts.