What is a custodial account?
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A custodial account is a financial account managed by one person for the benefit of another. Custodial accounts are commonly opened by parents as a simpler way to transfer assets to their children rather than setting up a trust, but they can also be used to save for their children’s future education expenses.
Establishing a custodial account can be a great way to help a child build a strong financial foundation, but there are a few important things to consider. Here’s what you need to know about custodial accounts and how they work.
What is a custodial account and how does it work?
A custodial account is generally any account opened and maintained by one party for another. However, custodial accounts are commonly thought of in one sense: an account controlled by an adult for the benefit of a minor, typically a family member.
Custodial accounts allow adults to give minors cash, securities, real estate, annuities, insurance policies and other assets more easily than setting up a trust.
How do custodial accounts work?
In general, the account custodian or custodians contribute to the account and determine how the money is invested or managed. Typically, custodians are parents, but they could be a guardian, relative or other adult.
Some accounts, such as Coverdell education savings accounts (ESAs) are designed for education expenses, but most custodial accounts, namely uniform transfer to minors accounts (UTMA) and uniform gift to minors accounts (UGMA) can be used for anything benefiting the minor. UGMA and UTMA accounts do not have a requirement to make a withdrawal.
An important feature to keep in mind is that contributions made to a custodial account cannot be adjusted or reversed. While the custodian can determine how funds are used, they cannot undo their contribution. Once the minor beneficiary reaches adulthood, they gain control of the account and can fully access and use the funds. If the minor passes away before reaching adulthood, the account becomes part of their estate.
Common types of custodial accounts
| Type of account | Availability | Annual contribution limit | Types of contributions allowed | Beneficiary restrictions |
|---|---|---|---|---|
| UGMA | All states | Unlimited, but contributions above $17,000 (in 2023), $18,000 (in 2024) per contributor may trigger the gift tax | Cash, securities and other financial assets | Once the minor reaches the age of majority (which differs per state), the account becomes theirs |
| UTMA | Every state except Vermont and South Carolina | Unlimited, but contributions above $17,000 (in 2023), $18,000 (in 2024) per contributor may trigger the gift tax | Cash, securities and other property | Once the minor reaches the age of majority (which differs per state), the account becomes theirs |
| Coverdell ESA | Joint filers with a modified adjusted gross income (MAGI) up to $190,000 can contribute up to the limit; contributions are reduced for MAGI between $190,000 and $220,000. | $2,000 per year; those with MAGI above $220,000 cannot open ESAs. | Cash only | When established, must be under 18 or have special needs; any money left after the beneficiary reaches age 30 must be distributed within 30 days, unless special needs |
A 529 education savings account can also be set up as a custodial account or as an individual account. For a breakdown of how a UTMA/UGMA account compares to a 529 college savings plan, see this article.
In addition, parents can open a Roth IRA for their children if the child has earned income.
What are the tax implications of a custodial account?
Your child must file taxes if he or she received unearned income of more than $1,250 (in 2023) or $1,300 (in 2024) or earned income of more than $13,850 (in 2023) or $14,600 (in 2024).
For UGMA/UTMA accounts, if the child’s interest, dividends and other unearned income is greater than $2,500, the income may be liable for a specific tax on unearned income.
For UGMA/UTMA accounts, if income from interest, dividends and capital gains amount to less than $11,500, it may be included on a parent’s return rather than filing separately for the child beneficiary, and taxed accordingly.
The first $1,250 of earnings in a UGMA/UTMA custodial account may be exempt from federal income taxes, while the next $1,250 is potentially taxed at a lower, “kiddie tax” rate of 10 percent. If a child’s unearned income exceeds $2,500, it’s taxed at a different rate and may be subject to the net investment income tax (NIIT) of 3.8 percent. IRS form 8615 is used to determine tax on unearned income over $2,500 for those under 18.
With a Coverdell ESA, contributions grow on a tax-deferred basis. Withdrawals for qualified education expenses are tax-free. But if withdrawals are made for other reasons, distributions are subject to a 10 percent tax penalty plus income taxes on the gains.
How does a custodial account affect college financial aid?
The legal ownership of assets can affect financial aid eligibility for education.
For a parent- or dependent-owned Coverdell ESA or 529 account, only up to 5.64 percent of the account’s value can be taken into account when determining college financial aid eligibility. If the family has a gross income of less than $60,000 and meets other requirements, then a 529 account is not factored into financial aid.
For UTMA/UGMA custodial accounts, account holders must contribute 20 percent of their assets before they can become eligible for financial aid, according to federal financial aid formulas. Custodial accounts are considered the student’s asset and not the custodian’s.
If you’re an independent student with no dependents, then a 529 account could decrease your financial aid as much as 20 percent. If you have dependents, however, this maximum rate drops to 3.29 percent.
How to open a custodial account
A custodial account can be set up at most banks and brokerages. But before getting started, it’s wise to shop around for account features such as no minimum deposit requirement, no maintenance fees and no commissions for online stock and ETF trades. The best brokerages offer many features, including the ability to invest in a wide range of assets. Another popular custodial account option is through a mutual fund company, such as Vanguard.
Custodial accounts are subject to the same rules as other bank or brokerage accounts. When opening an account, you’ll need to submit identifying information and supply the minor’s name, date of birth, and Social Security number in addition to your own if you’re serving as the custodian. Custodial accounts can invest in various types of assets, depending on the type of financial institution, but there may be restrictions on high-risk investments.
Bottom line
A custodial account is a great way to give minors cash, securities and other investments. That said, keep in mind the tax and financial aid implications and the fact that withdrawals must be used for the benefit of the minor.
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