As a parent, you want the best for your child. That means providing them with opportunities to succeed and get ahead in life.
One way to do that is by starting investments for them at an early age. A custodial account allows parents to start investing on behalf of their children while retaining full control over the account until they reach adulthood.
A child’s custodial account can teach them about investing – a laudable goal – but they also count toward the FAFSA and affect potential financial aid your child receives for college.
When opening a custodial account, you’ll want to plan ahead for the tax consequences of opening an account and whether better ways to save for college exist.
This post will discuss all types of custodial accounts, how they work, the tax rules for these accounts, how they affect college financial aid and what you need to know about each account type.
What is a Custodial Account?
Custodial accounts are financial accounts held in the name of a minor by one or more custodians.
Custodian is defined as “the person who manages assets for another” and typically refers to an adult who holds legal responsibility over the account on behalf of the child, usually their parent.
Though, a custodian can be the child’s parent, guardian, spouse of their parent, grandparents or another relative.
Custodial accounts are typically used to save and invest for a minor in hopes that they will be able to use their funds in a more productive way when they reach adulthood.
Once you have opened a custodial account, you can use it for a variety of financial goals, including college savings, retirement or general investment purposes.
Many use the account to teach some basic financial lessons about investing to their children. You can use the opportunity to discuss investment choices and outcomes, review account statements and give them a vote on major decisions.
The custodian has the responsibility to manage and invest funds accordingly with trust that they act in their best interest at all times.
Custodial accounts come in two flavors, a UGMA and UTMA account.
What is the Difference Between an UGMA and UTMA Account?
Both UGMA and UTMA accounts are similar in that they are custodial accounts with assets held within them for the benefit of the minor.
Where they differ are the types of assets that can be held within each.
UGMA (Uniform Gifts to Minors Act) accounts are custodial accounts typically set up by parents, guardians, grandparents or other relatives, who then serve as custodian for the child’s account until reaching the age of majority in their particular state.
In most places this is 18, but other places require the minor to be 21 or older.
When friends and family contribute money to a UGMA account opened through a bank or stock broker, they do not fall subject to annual contribution limits.
Though, when others make financial gifts, they become irrevocable, meaning they can’t be taken back from the minor once transferred.
For this reason, it may be important to consult a lawyer or other qualified professional before setting up an account.
UGMA accounts can hold purely financial assets like cash, stocks, bonds, mutual funds, life insurance policies, and other financial instruments.
UTMA (Uniform Transfer to Minors Act) accounts are also custodial accounts set up by parents or other custodians and are not limited to a certain dollar amount each year.
Where UTMA accounts differ is that they can hold any type of property, meaning they can hold the above financial instruments but also real estate and real property.
For example, you can place the deed to a home, car or other property into the UTMA account and transfer ownership to the minor.
Another key difference between a UGMA and UTMA account relates to state adoption policies. All states have adopted UGMA accounts but Vermont and South Carolina have not allowed UTMA accounts.
If you live in either of these states, you’ll only have access to UGMA accounts.
How Does a Custodial Account Work?
A custodial account works by having a parent, guardian or other custodian establish an account with a bank of broker offering these accounts.
The custodian makes or accepts contributions into the account and manages the underlying assets the funds invest in for the beneficiary.
Custodial accounts allow custodians to invest the money into a variety of assets. Most commonly, parents establish these accounts for children to build assets they will eventually own in the future.
Further, these investments can be carefully planned to provide the best chances for compounding returns by purchasing assets like index funds, individual stocks or mutual funds.
You can try a portfolio mixed with many different assets to teach your child how markets work and also with little money at risk to start.
Consider picking stocks in some of your child’s favorite companies like Disney (DIS), Netflix (NFLX), McDonald’s (MCD) or others. Several stock advice services can also point you toward stocks with significant long-term upside potential.
If you pick the right investments and hold them for a long time, this can maximize your child’s future financial prospects as well as your own if this makes your child financially independent.
After setting up an account, making contributions and choosing the investments to hold, you’ll need to be careful when managing the money in the account. This is especially true for any withdrawals that get made as you will want to remain mindful of the rules involved.
Custodial accounts require careful management because it is imperative that funds remain untouched until reaching age 18 or 21 depending on state law in order to ensure maximum benefits from compound interest over time.
Do Custodial Accounts Get Taxed?
Custodial accounts need to factor for the kiddie tax rules. This works by having any investment income earned in the account, including dividend, interest or capital gains income generated from assets held in the account, fall under the child’s tax rate once reaching the age of majority.
If your child is younger than the age of majority, the first $1,100 goes untaxed while the next $1,100 gets taxed at the child’s rate. If the account has earnings above this amount ($2,200), this counts as investment income that becomes subject to your rate as a parent.
Finally, individuals can contribute up to $15,000 per individual per year in gifts to the account without tax consequence ($30,000 per couple). Above this threshold, it triggers the federal gift tax limit.
Can I Invest with a Custodial Brokerage Account?
Absolutely. The primary point of opening a custodial account is to invest money in appreciating assets. Many parents and guardians use these accounts to invest for their kids and take advantage of compound interest.
Custodial accounts allow you to invest in stocks, bonds and mutual fund investments, but not riskier assets like stock options or choosing to buy on margin.
As mentioned above, because the account assets technically belong to the child, a certain amount of the investment income earned will go untaxed, fall under the child’s tax rate and then have remainder add to income taxed under the parents’ rates.
What is a Custodial IRA?
If your child or the minor has earned income, using a custodial IRA might be a tax-smart way to save their earnings for retirement.
A custodial IRA is an account set up and controlled by a custodian, usually the parents or guardian of the minor.
The IRA can be set up with any brokerage firm that offers custodial IRAs and is an excellent way to start investing for your child while retaining control until they reach adulthood.
Like other custodial accounts, custodial IRAs revert to the minor once reaching the age of majority. Minors can contribute up to $6,000 per year or their earned income, whichever is greater.
You’d likely want to consider a Roth IRA for your child, when their income tax rate is likely the lowest they’ll ever encounter. That way, they pay tax on the income now and it comes to them tax-free in retirement.
That gives you multiple decades of tax-free, compounded returns. That’s every parents’ dream!
You can open custodial IRAs with companies like Vanguard, Schwab and Fidelity.
Can You Withdraw Money from a Custodial Account?
Yes, but only when the funds withdrawn by the custodian use them for the benefit of the minor. Money contributed to a custodial account becomes property of the account beneficiary and the withdrawal must serve a fiduciary purpose, meaning it will go toward the benefit of the minor.
In short, you shouldn’t withdraw the money for personal needs and instead it should only go toward the expenses of the custodial account beneficiary. Talk to a financial professional to learn more about the specific rules regarding distributions taken from custodial accounts.
What is the Difference Between a Trust and Custodial Account?
The differences between a trust and custodial account are twofold: the level of simplicity for establishing a custodial account as compared to a trust and the greater flexibility and control that comes with a trust.
Can a Grandparent Open a Custodial Brokerage Account?
Yes, grandparents can open a custodial account for a grandchild. It can be beneficial for grandparents to open custodial accounts if they want to start saving and investing early on in their grandchildren’s lives, especially with the intention of passing along the funds or assets at some point down the road.
Do Custodial Accounts Affect Financial Aid?
Yes. Custodial accounts weigh more heavily on the scale of how much financial aid you are deemed to need for college. If you want to save for college expenses, you’re probably better served by using a Section 529 plan like one offered by Backer or an Education Savings Account (ESA).
These accounts factor less into you or your child’s ability to pay for college than would a custodial account. Further, a custodial account doesn’t carry the same tax advantages as either of these account types.
The assets of a custodial UTMA account are reported as the student’s asset on the FAFSA. Assets belonging to students may reduce financial aid by 20%. The custodial account is an investment account held for a minor.
If it’s transferred to a 529 plan, the expected family contribution (EFC) can be reduced by at least 14.36% (20% – 5.64% of the account value).
529 college savings plans get counted as a parent’s asset for dependent students. They get reported on the FAFSA and can reduce financial aid eligibility by 5.64%, less than the 20% of UTMA accounts.
In short, custodial accounts affect your eligibility for financial aid more so than other education-specific savings accounts. Further, if you as a parent want more control over the account funds, including the ability to change the account’s beneficiary, these other accounts give you that ability.
Custodial accounts have irrevocable asset transfers, meaning the money placed into the account cannot return to you.
Are Custodial Accounts Reported on FAFSA?
UGMA and UTMA accounts count as assets of the applying student and must show on the filed FAFSA form. If you are the custodian of an account but not the owner, you do not report these assets on your portion of the FAFSA.
What is the Best Custodial Account for Kids?
Now that we know a lot more about custodial accounts, it’s time to answer the question of where to open your custodial account. You’ll have no shortage of options available to you when deciding where to open an account, but you’ll likely want one with the ability to invest.
There is no black and white when it comes to “the best account,” but there are some considerations that can help you make a decision for what will work best for your individual financial situation.
- Fees. This is one of the most common considerations when choosing an account. Typically, custodial accounts have low or no fees if you are a customer with a brokerage firm. You may find some that charge trading commissions while others opt for a monthly fee and act as a free stock trading app within the account. Some even offer free stocks for signing up in the form of shares or a sign up bonus. Consider your preferred model.
- Account Minimums. Before opening an account, look into how much you’ll need to make as an initial deposit and the minimum account balance you’ll need to maintain.
- Investment Options. You’ll also want to think about the types of investment options you’ll have available. Some custodial accounts offer a wide range of investment choices while others provide guardrails with fewer choices but simplified offerings.
|App||Rating (out of 5)||Fees||Best For||Promotions|
|Acorns Early||4.8||$1/month - $5/month||Automated investing in the background into diversified investments||$10 sign up bonus when making first deposit at account opening|
|Greenlight||4.7||$4.99/month||Teaching investing fundamentals with guidance from parents||None|
|Stash||4.7||$1/month - $9/month||Everyday people looking to start managing their finances||$5 stock bonus for making a deposit of $5 or more|
|M1 Finance||4.3||$0 trading or automated investing; $125/year on M1 Plus subscription for custodial account||Fee-free active trading and automated investing||$30 sign up bonus with $1,000 deposit|
|UNest||4.5||$3/month - $6/month||Age-based investments in custodial investment account||Matching bonus with $25 initial deposit ($25 bonus)|
Because I like to keep my investing simple, I prefer choosing low-cost index funds and letting them compound over time. Therefore, my preferred custodial account brokerage is UNest.
UNest is a custodial account designed for investing toward your child’s future goals with great investments. This means being able to save for schooling, a first car, house, wedding or even establishing financial security for later in life.
The service provides five investment options, including age-based choices, and allows easy access to your account through a convenient mobile app.
You can even invite friends and family to contribute toward your UNest custodial account through a gifting link, perfect for the holidays, birthdays or other special occasions.
About the Site Author and Blog
In 2018, I was winding down a stint in investor relations and found myself newly equipped with a CPA, added insight on how investors behave in markets, and a load of free time. My job routinely required extended work hours, complex assignments, and tight deadlines. Seeking to maintain my momentum, I wanted to chase something ambitious.
I chose to start this financial independence blog as my next step, recognizing both the challenge and opportunity. I launched the site with encouragement from my wife as a means to lay out our financial independence journey and connect with and help others who share the same goal.
I have not been compensated by any of the companies listed in this post at the time of this writing. Any recommendations made by me are my own. Should you choose to act on them, please see the disclaimer on my About Young and the Invested page.