What is a custodial account?
From UGMAs to UTMAs and their pros and cons, find out what a custodial account is and how one can help you save for your child’s future.
Summary:
An adult controls a custodial account on behalf of a minor.
The minor assumes full control when they reach their state’s legal adulthood age.
There are two main types of custodial accounts: UTMA and UGMA.
These accounts are irrevocable and offer no tax benefits.
What is a custodial account?
The term ‘custodial account’ usually refers to a savings account that an adult controls for a minor. These savings accounts are available at brokerage firms, financial institutions, and mutual fund companies. If you are the custodian, you will need to approve account transactions such as selling or buying securities.
The term can also refer to any account that a fiduciarily responsible party maintains on behalf of a beneficiary. The fiduciary is legally and ethically obligated to act in the beneficiary’s best interests. One example of a custodial account in this sense is an employer-sponsored retirement account that a plan administrator maintains on behalf of eligible employees.
Whatever your reasons for looking into savings or other accounts that you can administer on behalf of someone else, a trusted financial advisor can help you navigate through setting one up and making it work for the beneficiaries. Let’s take a closer look.
How do custodial accounts work?
Once a custodial account has been opened, it works like any other account you would open at a bank or a brokerage firm. In most cases, an investment advisor or designated manager will be appointed the custodian, and they will decide how to invest the money. The account manager and others can contribute to the account.
The account custodian can choose to invest in a wide range of assets. However, many financial institutions don’t allow account managers to buy highly speculative investments, such as derivatives and features, or to trade on margin.
In the case of a custodial account for a minor, control of the account will transfer officially from the custodian to the beneficiary when the minor reaches their state’s legal age of adulthood (18 or 21, depending on their state of residence). When this happens, the beneficiary gains full control of the account and full use of the funds in it. If the beneficiary dies before reaching the legal age of adulthood, the account will become part of their estate.
Once the minor reaches the legal age of adulthood in their state, control of the account officially transfers from the custodian to the named beneficiary, at which point they claim full control and use of the funds. Should the minor die before reaching the age of majority, the account will become part of the child's estate.
Why would you want to open a custodial account?
There are a number of reasons to open a custodial account for your child, the child of a loved one, or a child in need. Here are some reasons to consider doing so:
To save for higher education: You can save effectively for your child’s higher education, including college fees.
To start teaching your child about investing: You can help your child understand the benefits of investing early for long-term compounding.
To lower household taxes: There’s a tax benefit for the first $2,000 in custodial account investment income.
To transfer a nest egg: You can transfer a nest egg to your child at a relatively low cost while you are still alive.
What type of custodial accounts are available?
There are two types of custodial accounts available. These include the Uniform Transfers to Minors Act (UTMA) accounts and the older Uniform Gift to Minors Act (UGMA) accounts. The biggest difference between them comes down to the type of assets you can contribute to them.
Created under state laws, these accounts hold transfers of funds to or gifts for a minor. The designated custodian usually is the minor’s parent or guardian.
The money or gifts contributed to the account belong to the minor. Those contributions cannot be revoked. The assets are reported under the minor’s Social Security number, and the account earnings are taxed as income, as the minor is the account owner. There are no restrictions on how the funds in these accounts can be used.
Uniform transfers to minors act (UTMA)
UTMA refers to a law that is an extension of the Uniform Gift to Minors Act. This law allows minors to receive gifts without a guardian or trustee’s aid. UTMA custodial accounts for minors allow appointed custodians or the gift giver to manage the account on behalf of the minor until the child reaches their state’s legal age of adulthood.
You can contribute money, fine art, patents, real estate, and royalties to a UTMA account. The account protects the minor from tax consequences on gifts up to a specific value. It’s important to remember that not all states have adopted UTMA law. UTMA accounts are not allowed in South Carolina and Vermont.
Uniform gift to minors act (UGMA)
Older UGMA custodial accounts for minors have greater restrictions on what you can contribute to them than UTMA accounts. UGMA accounts are limited to financial assets, including money, annuities, insurance policies, and securities such as bonds, stocks, and mutual funds.
As with UTMA accounts, an adult custodian manages the UGMA account until the minor beneficiary reaches the legal age of adulthood in their state of residence and assumes full control of the account. While UGMA account-generated earnings aren’t sheltered from tax, they are taxed at a lower rate for minors, up to a specified amount. These irrevocable accounts offer no tax benefits to you or other contributors.
The act that allows these accounts for minors was developed in 1956 and revised in 1966. The UTMA was finalized in 1986.
Work with a regulated financial advisor who can help you gain a deeper understanding of what a custodial account is and find the best option for your needs. Get matched with an advisor here.
What are the pros & cons of custodial accounts?
There are pros and cons to all investment options, even custodial accounts.
Find out more about them so you can make an informed decision if you’re considering opening one of these accounts for your child or the child of someone else.
Pros:
No restrictions on the use of funds
No contribution or income limits
Multiple investment options
Easy to set up
Learning opportunities for your child
Cons:
Money isn’t easy to access
Fewer tax advantages than other accounts
UGMA/UTMA accounts are irrevocable
Might affect financial aid eligibility
3 tips for custodial accounts
Finding and managing a custodial account is easier when you know how to do it. Use these three tips to get started:
Consider your goals and the child’s needs: Think about what you want to achieve as well as what the child needs when choosing a savings and investment option for them, especially if you want to manage the money they are gifted or inherit.
Think about other options: Consider all the options available, especially if you want to save your money for the child’s education – a 529 account can offer you more control, greater flexibility, and tax benefits.
Consult a reliable financial advisor: Speak to an SEC-regulated financial advisor who can help you explore the various options available to you, guiding you to make the best choice and helping you manage the account.
Need more advice on custodial accounts?
Custodial accounts offer a range of benefits and are a good way to save and manage money for your child’s future or the benefit of another child once they attain the legal age of adulthood.
If you’re thinking about opening a custodial account for a minor, let Unbiased help you find a regulated advisor who can assist you with understanding your options, creating an effective bespoke financial plan, and opening and managing a UTMA or UGMA account. Get in touch, and let us match you with the best financial advisor for your needs.
Senior Content Writer
Rachel is a Senior Content Writer at Unbiased. She has nearly a decade of experience writing and producing content across a range of different sectors.