What is a Custodial Account and How Do They Work?

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.

What is a custodial account?

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.

How does a custodial account work?

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.

Types of custodial accounts

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.

UGMA vs. UTMA accounts

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:

• There are no income caps or lifetime limits placed on gifts.
• Parents, grandparents, aunts, uncles or any other adult can make contributions.
• 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.
• There is only one beneficiary and one custodian.
• All gifts are irrevocable — once you contribute to a UTMA/UGMA account, that money belongs to the beneficiary.

Special federal tax rules apply to UGMA and UTMA accounts as well. (State income tax rules vary by state.)

• UGMA and UTMA accounts are not tax-deferred accounts. You can only contribute after-tax dollars.
• Unearned income — interest generated by the assets in the account — may be subject to the “Kiddie Tax”. This means the interest income will be taxed based on the rates for trusts and estates, not at the child’s parent’s income tax rate.

Coverdell ESAs

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.

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.

Is a custodial account right for me and my child?

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.

Custodial account alternatives

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.

• Trust accounts allow you to set your child as a beneficiary, but beneficiaries only gain access to those funds when you die. Trusts allow you more control over the funds, as you can specify how and when the money is paid out. You can even set up a trust so that you still have access to the funds in your lifetime.
• 529 Plan are an alternative to Coverdell Education Savings Account(ESA). 529 plans are savings accounts specific to college savings that allow parents, grandparents or other individuals to contribute money for college savings for a beneficiary. As an added perk, 529 Plan are doubly tax-beneficial. The money in a 529 account grows on a tax-deferred basis and withdrawals are not taxed as long as they are used for qualified educational expenses.
• Roth IRAs are most commonly thought of as a retirement savings vehicle. In reality, you can withdraw from your contributions — but not the earnings you’ve made on those contributions — at any time tax-free and penalty-free when you use it for education expenses. Roth IRA contributions are made with post-tax money. Plus, Roth IRA can offer an extra level of flexibility. If the money isn’t needed for college, parents can still apply it towards their retirement.