Discover the Secret of Custodial Accounts: A Guide to Protecting Your Children's Wealth

A custodial account is basically a saving account that is established and run by an adult for a minor. It can be held at a financial institution, a mutual fund company, or a brokerage firm. The adult controls the account on behalf of a minor who is under the age of either 18 or 21 years, depending on the laws of their state of residence. In order to perform transactions, such as buying or selling securities, the account requires permission from the custodian who is responsible for managing the account.

In a wider context, a custodial account refers to any account that is maintained by a responsible party who acts as a fiduciary on behalf of a beneficiary, such as retirement accounts managed by a plan administrator for eligible employees. A fiduciary is legally and ethically bound to act in the beneficiary's best interests.

Each state has specific regulations that govern the appointment of custodians and alternate custodians, as well as the age of majority.

Custodial accounts provide great flexibility, without any strict income or contribution limits or penalties for withdrawals. They also do not require distributions at any point. Contributions made to custodial accounts are irrevocable, meaning that they cannot be adjusted or reversed. Upon the minor's attainment of legal age, the account holdings permanently pass into their control, depending on their state of residence.

Once established, a custodial account functions like any other account at a bank or brokerage, with a designated manager or investment advisor acting as custodian who decides how to invest the money. It is also possible for others to continue contributing to the fund.

Custodial accounts can invest in various assets. However, the financial institution may not permit managers to use the account for trading on margin or purchasing highly speculative investments like futures or derivatives.

Custodial accounts come in two types: Uniform Transfers to Minors Act (UTMA) accounts and Uniform Gifts to Minors Act (UGMA) accounts. UTMA accounts can hold virtually any kind of asset, including real estate, intellectual property, and works of art. However, UGMA accounts are limited to financial assets like cash, securities, annuities, and insurance policies. UGMA accounts are legal in all 50 states, whereas UTMA accounts are not permitted in South Carolina and Vermont.

Both UGMA and UTMA have custodial accounts that are established in the minor's name, with a designated custodian, usually the child's parent or guardian. Different companies that hold the account have varying minimum account balances, initial investments, and interest rates.

It is possible to achieve tax benefits by opening custodial accounts, but there are also some drawbacks. For instance, such accounts may limit the amount of financial aid a child can receive for college.

Custodial accounts present increased flexibility. They do not have income or contribution limits, and there are no obligations to make regular distributions. Additionally, there are no penalties for withdrawing funds.

The requirement that all withdrawn funds be used "for the benefit of the minor" is somewhat unclear, and is not restricted to educational expenses, unlike college savings plans. As long as the beneficiary gains by it, the funds can be used by the custodian for anything ranging from housing to clothing.

Compared to trust funds, custodial accounts are less complicated and more affordable to establish. Both the UGMA and UTMA laws were designed to permit adults to transfer assets to minors without establishing a specialized trust structure allowing such ownership.

Although custodial accounts are not tax-deferred like IRAs, they provide some tax benefits. The IRS considers the minor child to be the account's owner, which means that the income generated is taxed at the child's tax rate up to a certain limit. Every child under 19 years old—24 if they are a full-time student—can have a certain amount of "unearned income" taxed at a reduced rate if they file as part of their parents' tax return.

For 2022, the first $1,150 in unearned income is exempt from taxes, while the next $1,150 is subject to a 10% rate. Income exceeding $2,300 will be taxed at the parent's rate. However, once the minor reaches the age of majority in their state of residence, they can file their own tax return. From that point, all the earnings from the account will be taxed based on the age of filing and the beneficiary's tax bracket.

During the 2022 tax year, an individual may contribute up to $16,000 to an account without being subject to the federal gift tax. This exclusion amount is scheduled to rise to $17,000 per individual for the 2023 tax year.

The child's ownership of the custodial account has pros and cons. Since the assets are considered holdings, they may limit their eligibility for financial aid or access to other forms of government or community aid when they apply to college.

Anything deposited or gifted to the account is irreversible. All of the account's holdings will be passed to the minor at the age of majority. In contrast to many college savings plans such as a 529 account, parents can continue to control the funds.

Although custodial accounts are not as advantageous for tax purposes as other accounts, transferring funds to an eligible 529 plan can help reduce the tax burden. However, to do this, any non-cash investment in the custodial account must be liquidated.

Furthermore, the beneficiary of a custodial account may not be altered, whereas the beneficiary on a 529 college plan may be altered within certain limits. Since the account is irrevocable, the account's beneficiary cannot be changed, and gifts or donations made to the account cannot be reversed.

Pros

Easy to establish and manage

No income, contribution, or withdrawal restrictions

A wide range of investment opportunities

Cons

Less tax-advantaged than other accounts

Could negatively affect a child's financial aid opportunities

When the time comes to transfer banking responsibilities to your offspring, you may be interested in learning more about custodial accounts. These accounts are available from a variety of sources, including both digital and physical brokerages, and are similar to regular individual accounts in terms of their length and structure.

For instance, you can utilize Merrill Edge's UGMA/UTMA online custodial account, which is supported by parent company Bank of America. Transferring funds from your Bank of America checking or savings account is simple, and there are no account maintenance fees or minimum deposits to worry about.

Banks also offer custodial deposit and checking account options in most locations.

Money can be withdrawn from a custodial account, as long as it's used for the minor's benefit - a flexible term that includes educational expenses and other costs.

Once the child turns 18 or 21, depending on your state's regulations, the account will be transferred to them.

A custodial account can be opened for you if you are below the age of majority and managed by an adult. The person who established the account will oversee it until you come of age, at which point it becomes your responsibility to manage.

According to the IRS rules, children file with their parents for tax returns. Earnings up to $1,150 are tax-deductible in 2022, with the next $1,150 taxed at the lowest rate of 10%. Any money above that is taxed at the parent's rate.

Custodial accounts are a useful method for adults to create a savings account for their children. The account is responsible for making investment choices and managing the money to benefit the child in some manner. Custodial accounts provide unique tax benefits but are not without risks, including possible reductions in financial aid availability. Be sure to balance the advantages and disadvantages before starting a custodial account.