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Investing

Could a Custodial Account Benefit Your Child?

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

Custodial accounts allow an adult to manage a child’s gifted or inherited money. Prior to the advent of 529 accounts and other college savings vehicles, this was a primary way for parents to fund college savings for children, grandchildren and other minor beneficiaries. But custodial accounts are still useful tools today — learn more about how they work below.

What is a custodial account?

A custodial account is a savings or investment account held at a bank, brokerage firm or other financial institution. It’s controlled by an adult for the benefit of a minor who is under the age of 18. A custodial account can be a way for parents or other adults to establish an account for college savings or other purposes for the benefit of a child.

The UGMA (Uniform Gift to Minors Act) and UTMA (Uniform Transfer to Minors Act) are popular versions of custodial account arrangements. Both types of accounts are similar and the best alternative between the two can often be a function of the rules of your state. There are some differences, however.

UGMA and UTMA accounts compared

Both types of accounts are a vehicle to house gifts made to a minor. Some similarities include:

  • No income caps or lifetime limits placed on gifts to either type of account.
  • Parents, grandparents, aunts, uncles or any other adult can make contributions to both types of accounts.
  • The adult can act as the custodian of the account or appoint another person or financial institution to act in this capacity. The custodian has a fiduciary obligation to the minor to ensure the assets are managed for their benefit.
  • For each account, there is only one beneficiary and one custodian.

Key differences include:

  • Gifts to a UTMA account can be made with virtually any type of asset, including securities, real estate, cash and others.
  • Gifts to a UGMA are limited to cash, securities and insurance policies.

There are also federal tax issues to be aware of for both types of accounts. (State income tax rules may vary by state.)

  • These are not tax-deferred accounts like a 529 plan of Coverdale Educational Savings Accounts (ESA). You can only contribute after-tax dollars.
  • Unearned income — income generated by the assets in the account —was formerly subject to the “kiddie tax,” which taxed this income at the tax rate of the minor’s parents. But as part of the 2017 tax reform rules, this unearned income is now taxed based on the rates for trusts and estates. Whether or not this is advantageous will vary by each individual situation.

Pros and cons of custodial accounts

No investing product is perfect, and as with any other option, custodial accounts have some potential benefits and drawbacks to consider.

Pros:

  • Custodial accounts don’t impose any restrictions on contributions or withdrawals. There’s a lot of flexibility in using these accounts, so long as it’s in the benefit of the child account holder.
  • These accounts are widely available at many financial institutions and are easy to open and access.

Cons:

  • Assets in a UGMA or UTMA account may impact the child’s federal financial aid application for college. About 20% of these assets will be expected to be used to fund the cost of higher education.
  • The assets of these accounts become the property of the child between ages 18 to 21, depending upon the state. The child is not obligated to use these assets for college or any other specific expense; they are in control. They could conceivably buy a car or anything else they desire, so it’s important to take your relationship with the child into account before establishing one of these accounts.

Like any type of financial account or investment vehicle, thought should be given as to what the objectives are for the assets. Custodial accounts can be a solid way to hold assets that are gifted to or inherited by a minor. However, if the specific objective is to save for their college education, there are some alternatives to consider.

Alternatives to custodial accounts

Interested in a custodial account to save for your child’s college education? If so, there are some other college savings vehicles to consider.

529 plans

These plans are established by each state that chooses to offer one. A 529 plan allows parents, grandparents or others to contribute money for college savings for a beneficiary. Each child will need to have their own account. The money in the 529 account grows on a tax-deferred basis and there are no taxes on the funds when withdrawn if the money is used for qualified educational expenses.

There are two types of 529 plans:

Prepaid tuition plans allow you to buy credits towards tuition at one or more participating colleges and universities. These plans are not guaranteed and may have restrictions as to the institutions where the money can be used. These plans cannot be used to pay for non-tuition costs like books or room and board.

Education savings plans are investment accounts in which the money contributed to the plan is invested in mutual funds, ETFs or other similar investments. Age-based accounts, which are similar to target date funds, are a popular choice in many plans. Funds from education savings accounts can be used for tuition and a host of other qualified higher education expenses such as housing, lab fees, books and more.

Money unused in one 529 account can be directed towards other family members including siblings, parents and children yet unborn.

Roth IRAs

Roth IRAs are most commonly thought of as a retirement savings vehicle. Contributions are made with after-tax dollars and the money grows tax-free. It can be withdrawn tax-free in retirement if certain rules are followed.

But Roth IRAs can also be used as a college savings vehicle. Your own contributions — but not the earnings you’ve made on those contributions — can be withdrawn tax-free. Moreover, you can make withdrawals without penalty if those withdrawals are for higher education expenses for yourself, a spouse or a family member. These withdrawals would still be subject to income taxes.

Roth IRAs can offer a level of flexibility when saving for college. If the money isn’t needed for college, parents can still apply it towards their retirement.

Custodial accounts offer an excellent way to manage assets for the benefit of a minor. They are versatile and allow for the flexibility that is often needed in this situation.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Roger Wohlner
Roger Wohlner |

Roger Wohlner is a writer at MagnifyMoney. You can email Roger here

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Investing

Here’s a Simple Guide to Understanding What Asset Allocation Is

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

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It’s important for investors to decide where and how to invest their money. Are stocks, bonds or perhaps cash the way to go? For many investors, a combination of these three basic asset classes may make sense.

A key component of investing is determining how to allocate your money among various types of investments — also known as asset allocation. Choosing the right asset allocation will balance out potential returns with potential risks.

What is asset allocation?

Asset allocation is based on the adage that you shouldn’t put all your eggs in one basket. In the case of investing, it’s about how you allocate your money between the three basic asset classes mentioned above. A proper asset allocation is one that balances an investor’s time horizon for their investment goals with their tolerance for risk (defined here as the risk of investment losses).

Within the three basic asset classes, there are a number of sub-asset classes to consider as well.

Stocks

Stocks are divided into sub-asset classes in a number of ways, but a key differentiator is market capitalization. Market cap is defined as the share price of a stock times the number of shares outstanding.

These are the basic types of stocks based on the market capitalization of individual stocks (or the average of stocks held in a mutual fund or ETF).

  • Large-cap stocks
  • Mid-cap stocks
  • Small-cap stocks

Large-cap stocks generally are larger companies, many of which are household names like Apple, Facebook, IBM, Johnson & Johnson and Microsoft.

Large-cap, mid-cap and small-cap stocks also can be divided into categories, such as growth and value. Growth stocks are companies that are growing faster than the average of a benchmark like the S&P 500, while value stocks may be undervalued compared to the average for the benchmark. Stocks classified as a blend are a mix of growth and value.

Stocks of domestic U.S. companies and companies headquartered outside the U.S. also are divided by market cap and investing style.

Bonds

Within bonds, there are a number of sub-asset classes. Some are based on the type of bond, such as government and corporate.

There are asset classes based on the maturity of bonds, including those with long-term, intermediate-term and short-term maturities. As a general rule, bonds with a longer time until maturity have a greater risk of price fluctuation over time. Bonds generally are less volatile than stocks.

Cash

Cash and cash-like investments generally are the least risky components of a portfolio and therefore generally offer the lowest returns.

Money market funds invest in a variety of short-term interest-bearing securities and are not insured by the Federal Deposit Insurance Corporation (FDIC). Money market accounts are government-insured, however.

Certificates of deposit (CDs) are interest-bearing accounts issued by banks. Your money is committed for a period (three months, a year, etc.), and you receive interest payments during that time while regaining access to your money at the end of the CD’s term. CDs are FDIC-insured.

Why asset allocation is so critical in investing

Asset allocation helps investors choose a mix of investments in line with their risk tolerance, time horizon and financial goals. A classic 1986 study by Brinson, Hood and Beebower asserted that over 90% of a portfolio’s return was determined by its asset allocation. While this has been debated over the years by financial professionals, regardless of the actual percentage, asset allocation is an important factor in your investment performance.

Asset allocation and the concept of diversification go hand in hand. Diversification is a process that mixes a number of different investments within a portfolio. The main idea behind diversification is that different types of investments will do well under varying market and economic circumstances.

Correlation between investments describes the relationship between the movement across two investments. This is a statistical measurement. A correlation of 1 between two asset classes or investment vehicles means the movement between the two is perfectly correlated. A correlation of -1 means there is no correlation and the two asset classes move in the opposite direction.

For example, U.S. large-cap stocks and bonds have a correlation of -0.18 with each other. This means that factors influencing the performance of large-cap stocks and bonds have a very low correlation. Additionally, the correlation between these two asset classes is negative.

A well-diversified portfolio uses an asset allocation that contains some holdings that are not highly correlated with each. This can mean that some investments will do very well when the stock market does well, while other holdings might lag the market at times.

Overall, having some holdings that are not correlated can serve to mitigate a portfolio’s downside risk.

How to choose an asset allocation that’s right for you

An investor who’s just starting out might have a portfolio that includes just a few holdings. It doesn’t take a large number of holdings to achieve diversification.

If you’re a younger investor, your initial asset allocation might be more aggressive and heavily tilted toward stocks. You have a long time until retirement, and the short-term ups and downs of the stock market really don’t impact you.

Your asset allocation will evolve over time. Goals such as saving for your children’s education, purchasing a home, starting a business and saving for retirement will be factors in determining the right one for your portfolio. These and other goals will have different time frames and needs that could impact your asset allocation.

Additionally, your asset allocation will need to be maintained. Investments will perform differently over time. You will want to rebalance your portfolio back to your target allocation periodically to ensure it properly reflects your risk tolerance.

For those who are not comfortable doing their own asset allocation, there are some options.

Target-date funds are professionally managed portfolios that are geared toward a target retirement date. For example, a 2040 fund would have an asset allocation that is geared toward someone who is retiring in or near the year 2040.

There are a number of asset allocation calculators available online for you to try out. These calculators typically will use a questionnaire to break down your situation — including your age, when you will need to access the money and other factors. Then, they will take this information and determine an optimal one for you.

Robo-advisors can offer another way for investors to gain access to professional asset allocation advice. These services utilize algorithms (formulas) to do an asset allocation for you based upon your situation. They generally are registered as financial advisors and will manage your investments for you.

A financial advisor routinely devises an asset allocation for their clients as part of the process of investing their money. A good advisor will review your allocation periodically and adjust it as your situation changes.

Bottom line

Asset allocation is a crucial aspect of investing for investors of all ages. A well-constructed one can help you realize your investing goals. It’s all about balancing your potential return against a level of downside risk. The right allocation can help you achieve your investment goals and not take excessive risk while doing so.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Roger Wohlner
Roger Wohlner |

Roger Wohlner is a writer at MagnifyMoney. You can email Roger here

Advertiser Disclosure

Investing

Understanding IRA Rollovers: 2 Charts to Help You

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

IRAs are a widely used retirement savings vehicle that offer versatility for savers. IRAs are often the account of choice when people leave a job and need a place to move their retirement funds from their former employer.

Moving money in or out of an IRA to or from another account is called a rollover. It’s important to understand how IRA rollovers work to use this option to your greatest advantage.

What is a rollover?

A rollover entails the transfer of retirement money from one plan to another. This might mean from an employer-sponsored retirement plan like a 401(k) plan to an IRA, or from one IRA account to another. It’s important to understand and follow the rules for performing a rollover so you don’t trigger an unwanted taxable event by doing things incorrectly.

In this article, we will break down the IRS rollover chart into smaller bits to help you understand various rollover rules.

3 types of rollovers

There are four ways to perform a rollover from one plan to another:

  • With a direct rollover, your account administrator moves money from your existing retirement plan, such as a 401(k), directly to an IRA account or to a new employer’s retirement plan. This is often the easiest and most hassle-free method to a rollover. No taxes will be withheld from the rollover amount.
  • A trustee-to-trustee transfer is used when taking a distribution from an IRA account. This means the financial institution that holds your IRA account will transfer the money directly to either an IRA account at another institution or to an employer-sponsored retirement account. This method allows you to avoid paying taxes on the transfer.
  • A 60-day rollover pertains to a distribution from an IRA that is directly paid to you. You will need to deposit the money in another IRA account or into an employer-sponsored retirement plan for the distribution to retain its tax-deferred status (and avoid any applicable fees). There is a mandatory tax-withholding when the distribution is made directly to you. To avoid paying taxes, you will need to deposition 100% or the amount distributed. This means that you will need to come up with the money withheld in taxes.

Before you consider a rollover involving an IRA, it’s important to keep the 12-month rule in mind. This rule applies to rollovers between IRA accounts, and only allows one rollover from the same IRA plan within one year.

Rollovers from an employer-sponsored retirement plan

It’s common to do a rollover from a 401(k), 403(b) or other types of employer-sponsored retirement plan when leaving an employer.

Rolling a balance into a traditional 401(k), 403(b), governmental 403(b), money purchase plan or a defined benefit plan (if there is a lump-sum option) to a traditional IRA is generally a matter of simply moving the money. These plans are typically funded with pre-tax money that has never been taxed.

Rolling a designated Roth account within an employer-sponsored retirement plan, such as a 401(k), to a Roth IRA account is also pretty straightforward since you are dealing with post-tax dollars in both cases.

Rollovers can sometimes be made into a new employer’s retirement plan if that plan accepts rollovers. However, it’s important to tread carefully when you attempt to roll over one plan type into a different type to ensure that the rollover is allowed, and that you are aware of any tax consequences. For example, rolling a 401(k) from your old employer to one at a new employer should be pretty straightforward. If the plans are different — for instance, moving a 401(k) to 403(b) — rollovers may or may not be allowed.

Money from a traditional IRA can be moved to a qualified plan that accepts rollovers, which is often a 401(k). In this case, the money from the IRA must have all originated from pre-tax contributions if rolled into a traditional 401(k) account. Performing this type of rollover will always depend on whether or not the receiving plan will accept such rollovers.

The chart below provides a quick glance at some rollover options when leaving a company:

Roll to:

Roll from:

Traditional IRARoth IRAQualified plan (pre-tax) 401(k), 403(b), 457(b)403(b)Governmental 457(b)Designated Roth account
Qualified plan (pre-tax) 401(k), 403(b), 457(b)YesYes1Yes2Yes2Yes2, 4Yes1, 3
403(b)YesYes1YesYesYes4Yes1, 3
Governmental 457(b)YesYes1YesYesYesYes1, 3
Designated Roth accountNoYesNoNoNoYes
Source: IRS
1. A rollover to a Roth IRA from one of these retirement accounts (in a non-Roth format) can be done, but this would constitute a Roth conversion that would result in taxable income.
2. Money from a qualified plan such as 401(k) plan can be rolled over to a qualified plan at another employer if the new plan accepts such rollovers. Typically, the funds have to be of the same type; for example, all contributions were made with pre-tax dollars.
3. Must be an in-plan rollover.
4. The 457 plan must have separate accounts.

Rollovers from a SIMPLE IRA

SIMPLE IRAs are a small business retirement plan. Participants in a SIMPLE IRA can generally roll money from or to a SIMPLE, but there are a few additional restrictions to be aware of.

Within the first two years of your participation in a SIMPLE IRA, you could face a 25% penalty for rolling your account balance from a SIMPLE IRA to another IRA or company retirement plan. However, you may avoid the penalty if you roll your SIMPLE IRA to another SIMPLE IRA account.

The two-year requirement would apply when you perform a rollover to a:

  • Traditional IRA
  • SEP IRA
  • Governmental 457(b) plan
  • Qualified plan (pre-tax)
  • 403(b) plan

Money can be rolled over to a SIMPLE IRA from most plans except a Roth IRA or designated Roth account within a retirement plan. Only one rollover to a traditional IRA or another SIMPLE IRA within 12 months is allowed.

Rollovers to and from an IRA

There can be any number of reasons to do a rollover from one IRA account to another. Perhaps you want to move to another IRA custodian that is a better fit for your needs. Or perhaps you have several IRAs and other retirement accounts scattered across various custodians or even old employers.

Consolidating these accounts in one place may be advantageous for you. Rollovers to and from IRA accounts have their own set of rules and it behooves you to understand them so as not to trigger an unwanted tax penalty. In this scenario, you’ll want to pay close attention to the 12-month rule and the 60-day rule discussed above.

Roll to:

Roll from:

Traditional IRARoth IRASEP IRAQualified plans (pre-tax)403(b)Governmental 457(b)Designated Roth account
Traditional IRAYes3Yes1Yes3YesYesYes2No
Roth IRANoYes3NoNoNoNoNo
SEP IRAYes3Yes1Yes3YesYesYes2No
Source: IRS
1. A rollover to a Roth IRA from one of these retirement accounts (in a non-Roth format) can be done, but this would constitute a Roth conversion that would result in taxable income.
2. The 457 plan must have separate accounts.
3. Only one rollover per 12-month period.

The bottom line

The ability to roll over to and from IRA accounts is one of their most attractive features. This tool can be handy to those saving for retirement as long as they take the time to understand the rules governing such rollovers.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Roger Wohlner
Roger Wohlner |

Roger Wohlner is a writer at MagnifyMoney. You can email Roger here