Understanding Custodial Accounts
A custodial account is a savings account held by an adult for a minor, with the adult acting as the account manager. Custodial accounts fall into two categories: Uniform Transfers to Minors Act (UTMA) and Uniform Gift to Minors Act (UGMA) accounts. While custodial accounts offer investment flexibility, they don't allow margin trading, futures, or high-risk investments. These accounts offer tax advantages and flexibility but might impact financial aid eligibility.
A custodial account is a savings account held by an adult on behalf of a minor (someone under 18 or 21 years old, depending on state laws) at a financial institution, brokerage firm, or mutual fund company. The adult, known as the custodian, manages the account and approves transactions such as buying or selling securities.
Custodial accounts also encompass accounts managed by a responsible party for a beneficiary, such as employer-based retirement accounts for eligible employees. A fiduciary, legally bound to act in the beneficiary's best interest, manages such accounts.
Custodial Account Function
Once established, a custodial account operates like a standard bank or brokerage account. The custodian, an appointed manager or investment advisor, decides how to invest the funds. Contributions can be made by the account manager or other entities.
While custodial accounts offer investment flexibility, they typically don't allow margin trading, futures, or high-risk investments. When the minor reaches adulthood, control of the account shifts to them, granting access to the funds. In case of the minor's demise before adulthood, the account becomes part of their estate.
Custodial Accounts Types
Custodial accounts fall into two categories: UTMA and UGMA accounts. These categories differ in the types of assets they can hold. UTMA accounts are versatile, accommodating assets such as real estate and art. In contrast, UGMA accounts are more limited, allowing only financial assets like cash, securities, annuities, and insurance policies. It's worth noting that UGMA accounts are available in all U.S. states, while UTMA accounts are prohibited in South Carolina and Vermont.
Both UTMA and UGMA accounts are established in the minor's name and require a designated custodian, typically a parent or guardian. The specifics, such as initial investments, minimum balances, and interest rates, vary depending on the hosting company. These custodial accounts offer a valuable tool for managing assets on behalf of minors while adhering to state-specific regulations.
Advantages and Disadvantages of Custodial Accounts
Custodial Account Advantages
- Flexibility: No income or contribution limits, and no mandatory distributions.
- Tax Advantages: Earnings are taxed at the child's rate until a specific threshold.
- Simplicity: Easier and less expensive to set up than trust funds.
Custodial Account Disadvantages
- Impact on Financial Aid: Account holdings could affect college financial aid eligibility.
- Limited Control: Deposits are irrevocable, and beneficiaries gain control at majority age.
- Tax Implications: Not as tax-sheltered as other accounts, and transferring to 529 plans can have tax consequences.
Obtaining a Custodial Account
If the minor is below the age of majority, which is typically 18 years old, an adult has the option to create a custodial account on their behalf. This custodial account can be managed by the adult until the child reaches majority age. During this time, the custodial account holder has the ability to make contributions, such as adding funds or investments, to the account in order to help the account grow over time.
The custodian appointed by the adult can also make investment decisions on behalf of the child, which can help to ensure that the account is being managed in a responsible and appropriate manner. Once the child reaches majority age, they can take control of the account and make their own investment decisions. Alternatively, the custodian may choose to transfer the account to the child at an earlier date if they feel that the child is mature enough to manage the account responsibly.
Minors are generally part of their parent's tax return, which means that their parents can claim their child's income on their own tax return. This can be beneficial because minors may not earn enough to be required to file their own tax return. Additionally, minors under the age of 18 are subject to the "kiddie tax" rules, which means that their unearned income over a certain amount is taxed at the parent's tax rate.
However, minors can still earn some income tax-free. For example, in 2022, minors can earn up to $1,150 tax-free. The next $1,150 is taxed at 10%, which is a lower rate than the parent's tax rate. Any additional earnings beyond $2,300 are taxed based on the child's parent's tax rate.
A custodial account empowers adults to open savings accounts for minors, managed by a custodian for the minor's benefit. These accounts offer tax advantages and flexibility but might impact financial aid eligibility. Before choosing a custodial account, weigh its pros and cons carefully.