What Is A Custodial Account? – Forbes Advisor

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As a parent, it’s natural to want to give your child every advantage you can. One way to give them a financial leg up is by opening a custodial account on their behalf. Custodial accounts are investment accounts that you open for a minor, where you act as the custodian, managing how the money in the fund is invested.

Custodial accounts can be useful tools, providing more flexibility than some options. But there are several drawbacks to keep in mind before opening an account.

What Are Custodial Accounts?

A custodial account is a type of financial account that an adult—such as a parent, grandparent or even a sibling—opens on behalf of a minor child. The custodian is in charge of managing the account, choosing how to invest the funds in the account until the child reaches the age of majority. Custodians have a fiduciary responsibility to act in the minor’s best interests.

Depending on the state, the age of majority ranges from 18 to 25. Once the child reaches the age of majority, they have complete control over the account and can withdraw the money as they wish.

In some states, custodians can elect to hold onto the custodial account until the child is older.

For example, in Florida, custodians can maintain control until the child reaches 25. However, the custodian must give the child notice at the age of 21 that the child has a 30-day window where they can opt to withdraw all of the account funds.

A key differentiating factor with custodial accounts is that the minor recipient cannot be changed. The designated minor is the sole owner of the account, and the funds cannot be transferred to another person.

Common Types of Custodial Accounts

There are several forms of custodial accounts, including custodial retirement accounts, but the most well-known and commonly used are the Uniform Gifts to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA) accounts.

Those accounts are created under state laws to hold gifts or transfers of funds to a minor. Once a gift or money transfer has been made, it belongs to the minor and cannot be revoked. As the owner of the account, the assets are reported under the minor’s Social Security number, and account earnings are taxed as income.

There are no restrictions on how funds in a UGMA/UTMA are used. Although the custodian can use the money to pay for the minor’s college education, the money can also be held and used for other purposes.

For UGMA/UTMA accounts, adult family members or court-appointed guardians can act as account custodians.

Advantages of Custodial Accounts

Custodial accounts like UGMA or UTMA accounts have several benefits.

The Minor Can Use the Funds for Any Purpose

There are many accounts you can open on behalf of a minor, such as 529 college savings plans. However, these accounts usually have restrictions—you can only use the funds in the account for certain purposes, such as the child’s college tuition, or you incur hefty penalties.

UGMA/UTMA accounts work differently. Once the minor reaches adulthood, the account ownership is transferred to them, and they can use the money for any purpose they wish. For example, the recipient can use the money for a down payment on a house, to buy a car after college or to start a business.

Multiple Investment Options

With 529 plans, you’re limited to your state plan’s investment options unless you’re eligible for a national plan in your state. But with a UGMA/UTMA account, you have more control and choices. You can invest in a range of stocks, bonds, mutual funds, exchange-traded funds, CDs and even more complex investments, such as options.

There Are No Income or Contribution Limits

With some accounts, there are limits on who can contribute to the account, and there are usually caps on how much money can be contributed. For example, only those who earn less than $220,000 can contribute to a Coverdell education savings account, and the maximum contribution permitted is just $2,000 per year.

With a UGMA/UTMA account, there are no income or contribution limits. But remember that gifts to an individual of $17,000 per year or more ($34,000 for a married couple) typically require you to file a federal gift tax form.

Drawbacks of Custodial Accounts

Custodial accounts can be useful tools, and custodians can use the accounts to teach children about investing and financial literacy. But there are some drawbacks to these accounts.

You Can’t Change Your Mind

Custodial accounts are irrevocable, so you can’t change your mind once you open an account or deposit money. If you deposit money into the account, you cannot withdraw it later if an emergency expense hits you.

Unlike some accounts which allow you to change beneficiaries, a custodial account can only be in one designated minor’s name, and that recipient cannot change.

The Money Isn’t Easily Accessible

The money in a custodial account is less accessible than with other accounts. Although a parent or guardian can technically make withdrawals, the withdrawals can only be used for the child’s benefit, and it cannot be used for expenses that are required of a parent. For example, you can’t take money out of a UGMA/UTMA account to pay for housing, food or clothing.

If you do take any withdrawals, you must keep diligent records of what money was taken out and how it was used, complete with receipts. Otherwise, there could be legal issues if the minor disputes how the funds were used.

It Could Affect the Child’s Eligibility for Financial Aid

Because custodial accounts contain assets held in the child’s name, they can affect the child’s eligibility for financial aid. The assets are given heavier weight than assets held in a 529 or education savings account, so it could limit the child’s eligibility for need-based grants and federal student loans.

They Lack the Tax Advantages of Other Accounts

Other account options, such as 529 education savings plans, may have tax benefits. For example, some states provide tax deductions for contributions made to 529 accounts. But custodial accounts lack those benefits. There are no pre-tax or post-tax advantages.

Alternatives to Custodial Accounts

UGMA/UTMA custodial accounts aren’t the only way to set aside money for a child. Depending on your circumstances, one of the following options may be a better choice.

529 Plans

A 529 plan is a tax-advantaged investment account you can use to save for a child’s future education expenses. Money in the account can grow tax-deferred, and if the withdrawals are used for qualifying education expenses, the withdrawals are tax-free.

Coverdell Accounts

A Coverdell education savings account is set up on behalf of a designated beneficiary, and the distributions are tax-free if they’re used for qualifying elementary, secondary or postsecondary education expenses.

However, not everyone is eligible for Coverdell accounts. There are income restrictions, and the maximum that can be contributed is $2,000 per year.

Trust Funds

Trust funds tend to be more complicated and expensive to set up than custodial accounts, but they can be a good option if you want to leave assets or property to your children. A trust acts as a legal entity that holds assets on behalf of the intended recipient until they’re eligible to receive them. For example, the child may receive the assets when they reach a certain age or when the previous owner of the assets passes away.

Opening a Custodial Account

If you decide to open a custodial account for a child, you can set up an account through most banks, financial institutions and some brokerage firms. To open the account, you’ll need the child’s legal name, Social Security number and birth date.

To get started, check out our picks for the best online brokers.

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