A custodial account allows an adult to manage a child’s money, often when gifted or inherited. For example, if your child is a minor and inherits assets like stocks, you’d set up a custodial brokerage account to manage those investments until they reach adulthood. You could also set up a custodial account at your bank to teach your child about saving and establish good money habits.
Custodial accounts come in several different shapes, each with its own features, benefits and tax rules. Whatever your reason for opening a custodial account, there’s an option for everybody.
In general, a custodial account is an account managed by an individual for the benefit of another. The account can be a savings account or custodial brokerage account held at a bank, online brokerage or other financial institution.
Typically, custodial accounts are controlled by an adult — usually a parent or guardian — for the benefit of a minor. They’re a good investment vehicle for parents to establish a college savings account or general wealth fund for their child.
Custodial accounts fall under the management of the adult account owner until the minor beneficiary turns 18 or 21, and sometimes as late as 25, depending on the state. This is sometimes known as the age of trust termination. Until then, the adult custodian has full control over the account, making deposits and managing investments in the custodial brokerage account as they wish.
Once the minor beneficiary reaches the age of trust termination, the custodian must transfer control of the account over to the now-adult beneficiary, who owns the account at that point. For custodians, transferring ownership is often as simple as signing into the account online, or perhaps calling the account issuer.
You can find custodial accounts at most financial institutions and brokerages. For example, you can open a custodial brokerage account at firms like Charles Schwab and Fidelity, or a custodial bank account at banks like Ally Bank or CIT Bank.
There are other rules and usage limitations surrounding different types of custodial accounts as well.
You can open almost any savings or investment account as a custodial account, depending on whether the bank or investment firm offers that option. You’ll open the account as usual, designating its ownership type during the process.
The most common types of custodial accounts you will see are UGMA (Uniform Gift to Minors Act), UTMA (Uniform Transfer to Minors Act) and Coverdell Education Savings Account(ESA). They each have their differences and unique benefits.
|Funds can be used for||Anything||Anything||Only qualified education expenses|
|Types of funds allowed||Cash, securities and insurance policies||Any asset, including real estate||Cash only|
|Contribution limits||None||None||$2,000 per year across all Coverdell ESAs|
|Tax treatment||Post-tax contributions; Unearned income may face “Kiddie Tax”||Post-tax contributions; Unearned income may face “Kiddie Tax”||Tax-free distributions; Non-deductible contributions|
|Age of trust termination||18 to 25 years old (varies by state)||18 to 25 years old (varies by state)||18 years old (unless special needs beneficiary)|
UGMA and UTMA accounts are often listed together by an institution when they’re offered. UTMA is a newer law that expands upon the original UGMA, and every state (except South Carolina and Vermont) follows the UTMA statutes, although you will still see both referenced often. The two accounts are pretty similar, and the better choice for you can often depend on the rules of your state.
The main difference between the two is how they can be funded. Gifts to a UTMA account can be made with virtually any type of asset, including securities, real estate, cash and others, while UGMA accounts are limited to cash, securities and insurance policies.
Other than that, their similarities include:
Special federal tax rules apply to UGMA and UTMA accounts as well. (State income tax rules vary by state.)
Coverdell Education Savings Account(ESA) are a custodial or trust account set up to pay only for qualified education expenses for the account’s designated beneficiary. Qualified education expenses include those for elementary, secondary and higher education. Coverdell Education Savings Account(ESA) beneficiaries must be under the age of 18 or be a special needs beneficiary.
Contributions to a Coverdell Education Savings Account(ESA) are not tax-deductible and must be made in cash by the contributor’s tax return due date. Additionally, while an unlimited number of Coverdell Education Savings Account(ESA) can be opened for a single beneficiary, contributions across all Coverdell Education Savings Account(ESA) for an individual must max out at $2,000 in any year.
Individuals and organizations may both make contributions. However, if an individual’s modified adjusted gross income (MAGI) is between $95,000 and $110,000 (or $190,000 and $220,000 if filing jointly), the $2,000 limit for each designated beneficiary is reduced gradually, based on your MAGI. If an individual contributor’s MAGI is $110,000 or more, they may not contribute to anyone’s Coverdell Education Savings Account(ESA).
When it’s time for the beneficiary to use their Coverdell Education Savings Account(ESA) funds, they can withdraw money tax-free to pay for their qualified education expenses. Once the beneficiary turns 30 years old, the funds in the account must be distributed elsewhere, unless they are a special needs beneficiary.
No investing product is perfect, and as with any other option, custodial accounts have some potential benefits and drawbacks to consider.
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.
You may consider a custodial account if you have kids and want to start saving money for them now. You can contribute as much as you need to as you watch your child grow. As they get older, you can include them even more in the process by showing them how contributions are made, how interest grows your money or how to choose investments inside their custodial brokerage account. That way, by the time they’re an adult and take control of the account, they’ll have gained valuable insight into how to best manage their own money. Find a financial advisor to help you decide if a custodial account is right for you.
If you want to impose stricter limitations on how your child can use the funds, however, then opening a custodial Coverdell Education Savings Account(ESA) is a better option. An ESA is also a more advantageous custodial account choice when it comes time to apply for college financial aid, as it’s considered the parent’s assets, not the student’s, and will therefore be weighted less. ESAs are also easier on your tax burden when it comes time to take distributions as they are tax-free.
Custodial accounts are a bit trickier tax-wise than, say, opening a simple savings account. If that’s more up your alley, you could open a separate high-yield savings account under your name with the sole goal of using it for your child’s college tuition later on, for example. With a savings account, you’re still contributing post-tax dollars like with UTMA and UGMA accounts. You may also still have to pay taxes on the savings account’s earned interest, if you earn more than $10 in interest in a year.
There are also a few alternatives to opening a custodial account. These accounts below offer different tax treatments, more control over funds in your lifetime and even retirement savings.