What Is a Custodial Account?

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. Understanding custodial accounts is essential for anyone looking to secure a child’s financial future or efficiently transfer generational wealth, making it a pivotal topic for financial planning and long-term stability. Custodial accounts serve as a powerful tool in building a solid financial foundation for the next generation.

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 in 2023

When it comes to contributing to custodial accounts, you have a good amount of freedom – there are no strict limits on how much you can put in and contribute. That said, contributions may trigger a gift tax if they exceed $17,000 for an individual or $34,000 for a married couple.

It’s important to keep in mind that contributions to custodial accounts are not tax-deductible, which means that they don’t provide immediate tax benefits. Additionally, unlike some other investment vehicles, custodial accounts do not offer tax-free growth.

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 (kiddie tax rate). This “kiddie tax rate” is nearly always lower than an adult’s rate and can lead to potential tax savings.

As of 2023, the rules state that the first $1,250 of unearned income is untaxed, the next $1,250 is taxed at the child’s rate, and anything over $2,500 is taxed at the parent’s marginal 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, mutual funds, 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

Uniform Gifts to Minors Act (UGMA) accounts are a bit more restrictive than UTMA accounts, which we’ll cover next, in terms of what types of investments they can hold. A UGMA account can only hold financial products such as:

• Stocks: Ownership in companies, which can offer the potential for high returns but also come with higher risk.
• Bonds: Loans to governments or companies, providing regular interest payments and eventual repayment.
• Mutual Funds: Professionally managed collections of different investments, offering instant diversification.
• Cash: Money market funds or cash equivalents, which are safer but typically provide lower returns.
• Certificates of Deposit (CDs): Time-bound savings accounts with fixed interest rates and maturity dates.

UTMA account

Uniform Transfers to Minors Act (UTMA) accounts are even more flexible than Uniform Gifts to Minors Act (UGMA) accounts. With UTMA, you can invest in things like real estate, artwork, collectibles, and even things like patents and royalties. This is great for passing down a wider range of assets to a minor.

One of the unique features of UTMA accounts is their handling of gifted assets, such as bonds, that have maturity dates extending beyond the minor’s age of majority. 

For example, let’s say someone gifts bonds to a UTMA account for a child. If these bonds have maturity dates that go beyond the age at which the minor gains control over the account, these bonds don’t automatically become accessible once the minor reaches adulthood. Instead, these bonds or other time-bound investments can keep growing until they reach their maturity dates.

This feature can be pretty helpful for managing investments with longer timelines. So, if you’re considering UTMA accounts, remember that they can offer this unique advantage of letting certain investments reach their full potential, regardless of the minor’s age.

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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: Trust funds involve legal intricacies and administrative costs that custodial accounts typically avoid. This simplicity makes custodial accounts accessible to a broader range of individuals.
• Lots of investment options: A wide range of investment choices allows you to align the investment strategy with the minor’s financial goals and your preferences.
• No withdrawal penalties: Custodial accounts don’t impose penalties for withdrawing funds. This means you can access the money when needed without worrying about extra charges.
• No income or contribution limits: Without income or contribution limits, you have the freedom to invest as much as you’d like to support the child’s future financial needs. Just keep gift tax in mind.
• Up to $2,500 taxed at a lower rate: A portion of the income generated within custodial accounts is often taxed at the minor’s usually lower tax rate. 
• Flexibility in using funds for child’s benefit: The money can be used for various purposes that contribute to the child’s well-being, such as education, clothing, living expenses, or even extracurricular activities.

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: When applying for financial aid, the value of the custodial account is considered as part of the child’s assets. Having a substantial custodial account can reduce the amount of aid the child is eligible for.
• No change in beneficiaries: Once a beneficiary is established for a custodial account, it’s not possible to change it.
• Gifts/deposits are irrevocable: Once the funds are transferred, they become the property of the beneficiary, and the custodian no longer has control over them. This means that the custodian cannot take the money back for their own use or redirect it to a different purpose. 

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.

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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?

Opening a custodial account isn’t limited to biological parents; it’s a flexible way for any caring adult to contribute to a child’s financial journey and set them up for a secure future. Any adult–grandparent, aunt, uncle, godparent, chosen family member, supportive teacher or mentor, 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.