A custodial brokerage account is a great way for adults to build a nest egg for a child. These financial vehicles offer increased flexibility over more traditional options like 529 plans and educational savings accounts. Plus, they’re cheaper and easier to establish than a trust while keeping an adult in the driver’s seat until the child comes of age.
Technically, any account maintained by a fiduciary for a beneficiary, such as a 401(k), qualifies as a custodial account. (A fiduciary is any entity ethically and legally bound to act on behalf of another’s best interests.)
But generally, “custodial brokerage account” refers to a financial account opened and controlled by an adult on behalf of a child. The adult acts as the custodian, making contributions and investment decisions until the minor reaches the age of majority. At that point, control of the account passes to the minor.
Financial institutions like banks, credit unions, mutual fund companies and brokerage firms all offer custodial accounts.
Custodial brokerage accounts are typically set up as UGMA or UTMA accounts (more on those below). These financial vehicles are established by an adult for a minor, who is the beneficiary and account owner. Anyone can contribute to the minor’s account, including parents or guardians, grandparents and friends.
Until the minor reaches the age of majority in their state, the custodian is responsible for all investment decisions. However, there are protections in place for the child. To start, all contributions are irrevocable, meaning they can’t be changed or undone. And while custodians can make withdrawals at any time, the funds must benefit the child directly.
That said, custodial accounts offer enormous flexibility compared to more traditional options. They have no income or contribution limits, nor distribution requirements or penalties. They also permit a broader range of investments than educational or 529 accounts. (Though, again, they do protect minors by limiting riskier investments.)
When the minor reaches their state’s legal age of adulthood – usually 18 or 21 – the account passes into their name. At that point, the custodian no longer has control over how the funds are invested or spent. If the minor passes before inheriting their account, it becomes part of their estate.
Custodial accounts offer a variety of investment options. Depending on whether an account is set up as an UGMA or UTMA, contributions and investments include:
That said, many financial firms don’t permit account managers to trade on margin or invest in highly speculative assets like derivatives.
Custodial brokerage accounts come with two tax considerations.
The first is from the contributor’s perspective. Each individual can contribute up to $16,000 per year without incurring a gift tax ($17,000 in 2023). Couples can contribute up to $32,000 ($34,000 in 2023).
From the child’s perspective, any realized earnings (like dividends, interest or capital gains) under $1,150 are exempt from federal income taxes. The next $1,150 in earnings is taxed at the child’s tax rate, which is generally 10%. However, generated income over $2,300 is taxed at the parent’s rate.
One potential downside of custodial brokerage accounts is their impact on financial aid. As the assets are held in the child’s name, they’re usually factored into financial aid decisions (such as FAFSA eligibility). If the account is hefty enough to limit aid but not enough to cover tuition, these assets can hinder a minor’s ability to afford college.
One aspect for custodians to consider is an account’s age of majority. States typically set this age between 18 and 21.
When the minor reaches this age, the account automatically and irrevocably passes into their name. This hands them complete control over the transferred assets, regardless of whether they’re ready for the responsibility.
Generally, when someone mentions a custodial brokerage account, they’re talking about an UGMA or UTMA. Both permit custodians to establish an account for a minor and make contributions and investment decisions. The particulars lie in which kinds of assets each account permits.
UGMA accounts are named for the law that birthed them: the Uniform Gifts to Minors Act. These custodial accounts limit contributions to financial-based assets like:
Currently, all U.S. states permit UGMA accounts.
Similarly, UTMA accounts are named for their establishing law: The Uniform Transfers to Minors Act. Unlike their counterparts, UTMAs can hold nearly any kind of asset, including:
Currently, South Carolina doesn’t permit UTMA accounts, while Vermont – the previously remaining holdout – now does.
The actual process of opening a custodial account varies between financial institutions. Generally, banks, credit unions, brokerages and other financial service companies offer custodial accounts. Each firm sets its own terms, including:
Regardless of where, opening an account is fairly easy. An adult can log in online or visit a firm in-person to set up a custodial account in a minor’s name. Generally, the adult will need their own personal information as well as that of the minor’s. (Including the minor’s Social Security Number.)
Once established, anyone can contribute to the account, including parents or guardians, relatives and friends. In the meantime, the custodian listed on the account manages all investment activities on the child’s behalf.
Custodial accounts provide parents and guardians with an excellent opportunity to teach kids about financial responsibility and investing in a constructive, supervised space.
Start by explaining that the money belongs to the minor, and that you’re saving and investing on their behalf. You may also show them their investment mix and performance reports to familiarize them with the process and terminology. After all, the goal should be to prepare them to make good stewardship decisions down the road.
As the minor ages into teenager-hood, you may enlist them in the decision-making process. They can research specific investments, develop their own preferences and voice their input. While the custodian maintains control over the account, hands-on experience can help the minor grow more knowledgeable and confident.
Anyone can contribute to a custodial account, including parents and guardians, grandparents, third cousins and your neighbors or friends. There are no contribution limits to the account and individuals can contribute up to $16,000 ($17,000 in 2023) without incurring a gift tax.
Yes, custodians can make withdrawals from custodial accounts. That said, consider that all contributions are irrevocable, meaning that they belong to the minor. Additionally, any withdrawals must benefit the minor directly.
You can open a custodial brokerage account as soon as the minor has a valid Social Security Number. The earlier you start saving and investing, the longer the assets can percolate and generate compound interest.
You can also open a custodial account as a Roth or traditional IRA. But you’ll have to wait until the child has an income, as contributions are limited to the child’s taxable earnings.
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