Could a Custodial Account Benefit Your Child?

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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.

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