When I was really young, I thought having money was just something that happened to adults. I figured that by the time I got older, all the money stuff would have worked itself out, and I’d be set, just like my parents seemed to be.
So when grandma would give me $100 on my birthday, I didn’t think twice before running to the toy store to scope out the latest and greatest in cheap plastic.
Years later, what struck me as I looked at college tuition bills, the cost of a new home, and wedding venues, is that everything costs money. And most of the time, it costs a lot more than you think it should.
I think about all of the years I spent squandering away money and what a difference it might have made in my life today if it had been invested in my future and not in the local toy stores.
I don’t fault my parents for my lack of financial education. I grew up in a time where it was taboo to talk about money. But thankfully, for future generations, those times are changing.
Parents today are presented with so many amazing opportunities to set aside money for children. And the best part is, kids can get involved and educated in the process.
What is a Custodial Investing Account?
One of the best ways a parent can educate and get their child involved in money at an early age, is to set up a custodial investing account.
Sometimes referred to as a UTMA/UGMA (Uniform Transfers/Gifts to Minors Act), is a brokerage account for investing created by a parent or custodian that belongs to a minor child.
Within the account, the custodian can choose to invest in stocks, bonds, mutual funds, etc. Based on your state’s rules, funds are automatically turned over to the child at the age of majority, which is often at age 18 or 21, depending on your state.
These accounts are commonly used to transfer wealth, hold college savings, or use as a place to collect financial gifts from friends and family for celebrations like birthdays.
As I think about how I used to squander away my birthday money, I can only wish my parents had placed those funds into an account and enabled me to learn about investing alongside them.
A custodial investing account is an opportunity to teach children about the stock market and why it’s wise to keep assets there over a traditional savings account.
Letting kids know how the account works can also lead to better decision-making down the road when the child receives access to funds while they’re still relatively young.
Not only does it teach kids about investing, but it can allow them to start investing as early as possible, giving them even more time to build wealth. Imagine if you had an extra 10-20 years to build wealth?
This is something that a parent can give to their child, and the interest on starting a custodial account early can pay a lifetime of interest for a child. (no pun intended).
How do Custodial Investing Accounts Work?
There are a few key things to know about a custodial investing account.
- Anyone can open one. As long as you have the necessary information to identify a minor child, like name, date of birth, and SSN, anyone, including parents, grandparents, aunts, and uncles, can open a custodial account.
- Contributions are irrevocable. That means once you put funds in, they cannot be removed except to benefit the named minor.
- Custodial accounts are non-transferable. The identified beneficiary is the only one who can benefit from funds in the account.
- There are no contribution limits. This is one reason a custodial investing account is an excellent option for wealth transfer.
- There are no income limits. High-earners specifically may benefit from using a custodial investing account.
- There are no withdrawal penalties. But funds do need to be used to benefit the minor child listed on the account.
Who Owns the Funds in a Custodial Account?
Think of the custodian as the shepherd watching over a flock of money, making sure it continues to grow until the child is old enough to take over.
The flock belongs to the minor child. But until they reach the age of majority and can stand watch, any changes to the flock need to be approved by the custodian.
While irrevocable contributions can be made by anyone, including parents, family members, friends, or even the minor child themselves, the account’s assets ultimately belong to only the minor child.
Therefore, any transactions or withdrawals on a custodial account before the child reaches the age of majority may be made only by the custodian. And that money must legally be used for the benefit of the child.
What are the Tax Implications?
Because the assets within the account belong to the minor child, growth on assets will be filed on the child’s taxes.
The good news is that since the tax is just on growth, many accounts will come under the lower limit and not need to pay. In 2021, up to $1,100 in earnings and dividends are tax-free.
The subsequent $1,100 is taxed at the child’s rate, and any earnings that exceed $2,200 are taxed at the rate for trusts and estates (thanks to what’s called the “Kiddie Tax”).
If you’re looking to deposit a boatload of funds into a custodial account, be aware that anything beyond $15,000 per account ($30,000 for both parents) will trigger the need to file a gift tax return.
Pros and Cons of a Custodial Investing Account for Parents and Kids
There are several benefits to setting aside funds in a custodial account.
- Teaching kids about investing. I firmly believe that parents are the primary form of financial education for kids today. And failure to discuss money at home can only lead to issues down the road. When you choose to open a custodial account, talk to your child about what it is, why you’re doing it, and what it means for them down the road. The more time you spend talking to them about it now, the smarter decisions they may make when it comes time for them to receive the funds.
- Ability to use funds for any reason. While the child is still a minor, any withdrawals will need to be for the child’s benefit. After a child takes over access to the account, at 18 or 21, they can use it for any reason, like a wedding, day-to-day living expenses, or a new car.
- Flexibility of contributions and withdrawals. Custodial accounts have no income limits, contribution limits, or withdrawal penalties. This immense flexibility in getting money into and out of the account makes it an excellent choice for parents who don’t necessarily want to earmark funds for college savings.
But before you jump into opening an account, it’s also worth considering the downsides and alternative options.
- There may be impacts to financial aid. If your child plans to apply for financial aid, 20% of funds in a custodial account will be considered. That means schools may require that the minor child cover a certain percentage of their educational expenses. And that amount will be much higher than if the parent’s financial status were considered.
- Money cannot be transferred to another minor child. A custodial account has one beneficiary, which is non-transferable. The only way to transfer funds to another child would be to wait until the initial beneficiary reaches the age of majority and have them withdraw and transfer funds into another account. But that gets complex and could be messy when you consider tax implications.
- Irrevocable contributions can sometimes lead to regret. Truthfully, I don’t think I was worthy of receiving a substantial sum of money at 21 years old. If you genuinely want to benefit a child but have concerns that they may be irresponsible about it later in life, it could be a better move to put it in a trust, 529 or taxable brokerage account that you turn over to them at a later age.
Are Custodial Investing Accounts and 529s the Same?
Covering college savings is often the first thing that comes to mind when people think about setting kids up financially.
That was certainly my thought when I considered how to set aside money for my niece and why I went with a 529.
A 529 college savings plan is a tax-advantaged account where parents, family, or friends can contribute funds that eventually will be used by a child for education-related costs.
Contributions are deductible on some state income taxes, and money in the account grows tax-free and is untaxed if used for qualified educational expenses.
The key differences between these types of accounts are:
- Transferability: A 529 plan can be transferred to another child or even adult for educational expenses. A custodial account is tied to a single beneficiary forever. This is one of the biggest reasons why I opened a 529 plan for my niece. I have no idea what her future may hold. So if she chooses to end her education after high school, I can transfer the account to my own future children or future nieces and nephews.
- Tax benefits: In some states, contributions to a 529 plan are tax-deductible. The funds inside a 529 also grow tax-free if used for qualifying educational expenses.
How to Open a Custodial Investing Account
If a custodial investing account seems like the right option for your financial goals, opening one is very similar to opening a brokerage account for yourself.
- Do your research and compare account types. A custodial account can be a good option for transferring funds to children. But make sure you fully understand the ins and outs and that you wouldn’t be better served by a 529 or keeping funds in your name. (It can sometimes be best to consult with a tax attorney if you’re looking to maximize tax benefits).
- Check fees and account minimums at different institutions. Since custodial accounts are so flexible in terms of contributions and withdrawals, you’ll just want to be sure to choose a bank that has low or no-fee accounts with low or no account minimums. That means funds deposited in the account have maximum growth potential.
- Apply online or over the phone. Nearly all applications for a custodial account can be completed online or via phone. Ensure you have all the necessary personal information for both you as the custodian and the minor child, including name, birthday, SSN. Don’t forget the information for the bank from where you’ll be transferring funds.
- Start investing and involve the minor child. When the child is old enough to understand money, seize the opportunity to teach them about the markets. Maybe even let them choose an investment they’d like to add to the portfolio. This can be a great way for kids to feel empowered and confident enough to make better investing decisions when they’re fully out on their own.
The Bottom Line
I can’t help but dream about how I may have avoided student loans or bought a house in my 20s if I had access to a custodial investing account when I grew up.
Just affording kids the opportunity to turn birthday and holiday money into a meaningful wealth-building tool is so incredibly powerful. And it’s definitely something I plan to start for my future children one day.
Helping kids learn about investing at an early age is one of the best ways parents can set kids up for future financial success.
And accounts like a custodial investing account are a great teaching tool that can give children a nice cash cushion to fall into when they get into the adult world and, like I did, realize just how much life costs.
A custodial investing account is a highly flexible way to set aside funds for your child’s future. And it can also be a great way to prepare kids to do their own investing later in life.
With the added benefits of no limits on contributions or income and penalty-free withdrawals, a custodial account is a wise move that will set your kids up for success out of the gate.