< DICTIONARY

Custodial Account

A financial account set up by an adult for the benefit of a child and managed by the adult until the child reaches adulthood and control is transferred over to the child.

The account is legally owned by the child beneficiary.

There are different types of custodial accounts, including custodial bank accounts, custodial investment accounts, and custodial retirement accounts.

Custodial Account

What is a Custodial Account?

Custodial accounts are financial accounts (bank accounts, investment accounts, or other) owned by a minor and managed by an adult. The adult (also known as the custodian) is in charge of managing the financial account to benefit the child (beneficiary) until the child reaches a certain age and takes full ownership and starts active management of the account.

Custodial accounts are an excellent way to start saving and investing for a child’s future.

Custodial accounts are an excellent way to start saving and investing for a child’s future. Custodial accounts can be used to teach kids about finances, to show them how to manage their own money and to show them how banking and investing works.

Teaching financial literacy from a young age can help set up kids for financial independence and success as adults.

Introducing kids into their own finances through a custodial account can build healthy money habits in them.

Since the accounts are legally owned by the child, they are taxed at the child’s tax rate. This provides a small tax benefit to these accounts over investing in your own accounts and later transferring the funds to the child.

Types of Custodial Accounts

There are different types of financial accounts that an adult can open for the benefit of a child as custodial accounts.

Different types of custodial accounts have different rules and tax benefits and can help hit different goals.

Teaching financial literacy from a young age can help set up kids for financial independence and success as adults.

Common goals are setting kids up for college, retirement, teaching them about saving and banking, teaching about investing in stocks & bonds, and generally saving & investing for adulthood and a bright future.

Custodial Brokerage Account – UTMA / UGMA Accounts

A taxable investment account that allows an adult to buy and sell a variety of investments on behalf of a child. The investments are owned by the child and managed by the adult until the child reaches adulthood.

Custodial investment accounts are sometimes also known as UTMA Accounts or UGMA Accounts.

Custodial brokerage accounts are great to teach kids about investments and to set them up for any goal they have as adults, no strings attached.

Custodial brokerage accounts are flexible and allow the child the use the funds for anything when the child is an adult. However, they don’t offer any tax benefits beyond being taxed at the child’s tax level.

These accounts are great to teach kids about investments and to set them up for any goal they have as adults, no strings attached.

Custodial Traditional IRA

Custodial traditional IRAs are investment accounts that allow an adult to buy and sell investments on behalf of a child for that child’s financial security in retirement in a tax-deferred way.

In addition to retirement savings, IRAs funds can be used for other qualified expenses like a first home purchase or college tuition.

The same rules that apply to a regular Traditional IRA apply to custodial Traditional IRAs.

In plain English, this means you can invest money by buying stocks, ETFs, and other investments through an account that is legally owned by the child, and the child only has to pay taxes on earnings in retirement when pulling out funds.

This is a great tool for parents and grandparents that want to set kids up for financial security in the long run.

However, like in a regular traditional IRA, you can only open and contribute to this type of account if the child that owns the account has taxable compensation.

Contributions to traditional IRAs may be tax deductible.  

Traditional IRAs defer tax payments to a later phase in life, when your tax rate is lower than today’s. This makes Traditional IRAs less ideal for kids, since children most likely have the lowest tax rate of their lifetime.

A Custodial Traditional IRA means less taxes today for your kids and pushing those taxes for tomorrow.

These make Roth IRAs a more popular retirement investment tool for kids, not Traditional IRAs. 

Custodial Roth IRA

Custodial Roth IRAs are investment accounts that allow an adult to buy and sell investments on behalf of a child for that child’s financial security in retirement with tax-free distributions in retirement.

In addition to retirement savings, IRAs funds can be used for other qualified expenses like a first home purchase or college tuition.

The same rules that apply to a regular Roth IRA apply to custodial Roth IRAs.

With a custodial Roth IRA, you can contribute after-tax dollars to the child’s account (again, as long as the child has taxable income), invest the funds, and then the child can pullout money in retirement without paying any additional taxes on the investments.

Since children typically have low income and low tax rates, Roth IRAs make the best vehicle to save for their retirement. They enjoy a lower tax rate today, and no taxes tomorrow.

Keep in mind, to open any kind of IRA, the child needs to have taxable income.

Custodial Savings Accounts and Custodial Bank Accounts

If you’re simply looking for a safe place to hold money and savings for a child, this is the account for you.

A custodial Savings Account or custodial bank account is a bank account owned by the child and managed by the adult. Active management of the account is transferred to the child when the child becomes an adult.

Some banks and financial institutions offer this as an option, but not all of them. Other banks may offer Joint Accounts for parents and kids. In addition, banks have different age limits for setting up accounts and for providing access to the kids.

A custodial savings account is safe and a good place to start, but considering the long period of potential compounding interest, it may lead to losing additional potential earnings and returns on the money that investment accounts can get.

How to Open a Custodial Account

Before you set out to open a custodial account, choose the type of custodial account that best fits the child’s financial goals.

  1. To open an account for a child, you’ll need to prepare your and the minor’s personal identification information, including social security number, date of birth, contact info and address.
  2. Head to the financial institute’s website (or walk into a brick & mortar location) and set up the account.
  3. Deposit funds and financial gifts into the account, then start managing the account until the child is of age.

Custodial Account Rules

Custodial accounts are set up by an adult for the benefit of a minor. They are legally owned by the minor and managed by the custodian adult until that minor becomes an adult.

When the child reaches the age of majority (becomes an adult), control of the account needs to be handed over to the child. The newly young adult can then decide what to do with the funds.

The exact definition of the age of adulthood varies in different states, typically ranging from 18 years old to 25 years old.

At some financial institutions, the account may become restricted once the child passes the state-mandated age until control is transferred over.

When the child reaches the age of majority (becomes an adult), control of the account needs to be handed over to the child. The newly young adult can then decide what to do with the funds.

During the time that the custodian is managing the account, the funds are to be used for the benefit of the child. This is actually a broad definition, and in the case that the custodian is the child’s parents, may actually include benefiting the parent or family as a whole, since the parent is the child’s caregiver.

Since the account is owned by the minor, it is taxed at the minor’s tax rate, at least until the rate of theKiddie Tax. This provides a potential tax benefits on the account’s profits up to a ceiling, and then gets taxed at the parent’s tax rate.

The funds in the account may factor as assets that belong to the child when calculating financial aid for college.

Contributions into custodial accounts count as financial gifts, and may require the adult to fill out a gift form with the yearly tax return.

Contributions are also considered irrevocable gifts, meaning you can’t take them back. Both the funds and the account are legally owned by the child.

Frequently Asked Questions

How much money can you put in a custodial account?

While there is no limit to the amount that can be held in a custodial account, there is a yearly gift contribution limit.

If you contribute more than the yearly gift limit, you may be required to disclose the gifts with your yearly tax return. In that case, the gifts may also qualify for the lifetime gift tax-exclusion.

Since money in custodial accounts may be held in the accounts for long periods of time, make sure to check that they have proper federal insurance in case something happens to the financial institution (not to your investment).

For bank accounts FDIC insurance can cover up to $250,000 of deposits per account, and for investment accounts SPIC insurance can cover $500,000 of securities and $250,000 of cash in the account.

Can parents take money out of custodial account?

You can take out money from a custodial account in two scenarios – the first is when the child reaches the age of majority (18-25), and the second is when the adult custodian needs it for something that benefits the child.

This means that the adult can use some of the funds to pay for different expenses that benefit the child, from education costs to summer camps, and even the kid’s first car.

Custodian accounts also allow parents to use the funds for their own living expenses, since paying for their expenses helps them support the minor.

What happens to a custodial account when the child turns 21?

Control of custodial accounts need to be transferred to the child when the child turns 18 (or 21 or 25, depending on the state).

Once the account is transferred to the child, the child can choose to keep using the account, or take some or all of the cash out of the account.

At some financial institutions, the accounts become restricted accounts once the child passes the state-mandated age until control is transferred to the new young adult.

Once the account is transferred to the child, the child can choose to keep using the account, take some or all of the cash out of the account.

It’s completely up to the child what to do with the account.

Who pays taxes on a custodial account?

Custodial accounts are legally owned by the beneficiary child and are subject to the child’s tax rates.

If your kids have income-generating investments or interest in the account, profits on the investments are considered “unearned income” and are taxed at the child’s income tax level, usually lower than the parent’s tax rate.

Dependents have a standard deduction of $1,150 on unearned income, meaning they don’t need to pay any taxes on unearned income if it is less than $1,150 for the year 2022.

However, if the earnings in the account are more than $2,300, the Kiddie Tax kicks in and anything above that is taxed at your (the parent’s) tax level.

If the custodial account earns less than $1,150 in a year, you and your child won’t have to pay any taxes on it. If it earns more than $1,150 and less than $2,300, your child will owe taxes on the earnings above $1,150 based on the child’s tax rate.

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