What is a custodial account?

December 23, 2020
financial literacy

Let's face it: we all want to know we're giving the next generation the best possible start in life — and one of the biggest and most important gifts you can give the children in your life is financial freedom.

There's a huge world out there, and so many opportunities.

Maybe they want to become an entrepreneur and start a new business, go to college, or just take a gap year and do some traveling.

When your loved ones come of age, you want them to be able to chase their dreams, right?

The good news is that you can make sure they have that chance.

But to give your sons, daughters, grandkids, god kids, nieces or nephews that gift of financial freedom when they hit a certain age, you've got to start saving now.

There are quite a few savings accounts and investment vehicles out there to choose from. But one of the simplest and most flexible financial tools you can use to invest in the children in your life is a custodial account.

This guide will explain what a custodial account is, what it can be used for, how it's different from a 529 plan, and the rules around custodial accounts you should bear in mind before contributing to one.

What is a custodial account?

A custodial account is a financial tool that adults can use to save money for a child to access and spend when they come of age.

When an adult opens a custodial account, they become its custodian.

They then handle managing the cash or investments placed into that account until the child is no longer a minor and reaches the "age of majority."

The age of majority varies from state-to-state. But ordinarily, it's either 18 or 21.

When the child hits the age of majority in their state, every asset in the custodian account becomes their legal property.

When the child hits that magical age, the adult (or custodian) will cease to have control over the account, and the child will be able to continue to keep the funds invested or use the money as needed.

What can a custodial account be used for? 

A custodial account could be used to pay for a trip around the world, a wedding, business start-up, college tuition, or anything in between.

Unlike some other savings devices, custodial accounts aren't constrained by pesky definitions of what is a "qualified expense".

The assets that kids get when they take ownership of a custodial account are essentially a gift with no strings attached.

They can use the money in whatever way their heart desires. 

Who can create a custodial account? 

One of the special things about a custodial account is that it doesn't have to be a tool that a parent uses to save for their son or daughter.

Custodial accounts can be used by parents, guardians, aunts, uncles, or other relatives to help save money for a minor. 

Simply put: it doesn't matter what the relationship is. If there's an important kid in your life and you want to help give them the gift of financial freedom when they hit adulthood, you can open a custodial account for them or contribute to an existing account that somebody else has already set up for them.

But, until now, custodial accounts have been limited on who's allowed to contribute to an existing account.

For example, let's say your brother has a custodial account for his daughter, and you want to contribute money as a gift for your niece's birthday.

Traditional custodial accounts wouldn't allow you to fund directly. You'd have to give the money to your brother and ask him to deposit it for your niece. Or go through the hassle and paperwork of setting up a new, separate custodial account for your niece, where you’d be the custodian. 

Third-party contributions haven't historically been possible.

That's all changing thanks to EarlyBird.

With EarlyBird, a parent or guardian can set up a custodial account and then multiple people can make their own contributions whenever they'd like.

That means aunts, uncles, cousins, friends, co-workers, or anybody else can swiftly and directly deposit contributions into a child's custodial account without having to make multiple transfers, talk to banks or get lots of people involved.

It makes gifting money so much easier, and it also means your child's savings power will increase exponentially because anyone can contribute.

What types of custodial accounts are there? 

There are two types of custodial account types that you can use to save for minors: UGMA accounts and UTMA accounts.

These custodial account types are named after the Uniform Gifts to Minors Act and the Uniform Transfers to Minors Act (respectively), which are the federal laws that created them.

What's the difference between UTMA and UGMA custodial accounts?

Ok: so you've decided you're interested in setting up a custodial account for the kids in your life. Which account type do you go for? 

There are two custodial account options.

Your first option is the UTMA, which is named after the law that introduced this account type (the Uniform Transfers to Minors Act).

With UTMA accounts, you're able to invest cash and most common investment-related assets (like stocks, bonds, mutual funds, annuities, and other insurance account assets).

UTMA accounts can also hold alternative assets (like real estate, jewelry, collectibles, and intellectual property).

Next, you've got UGMA accounts.

UGMA accounts are named after the Uniform Gifts to Minors Act, and they're able to hold all of your most common traditional forms of investments. This includes all of the same common investment-related assets that UTMAs can hold.

Unlike an UTMA account, UGMAs aren't designed to hold alternative investments. But often, UGMAs are going to be preferable because they're allowed in every US state.

All states allow adults to open UGMA custodial accounts for minors. But UTMA accounts aren't allowed in Vermont and South Carolina, which never adopted the Uniform Transfers to Minors Act. 

That means if you or the minor you're saving for live in these states, you're going to want to set up an UGMA account instead.

It's also important to bear in mind that no matter which type of custodial account you go for, the financial services company running your account will typically have its own restrictions on the alternative investments you put into the account.

You can't normally engage in high-risk buying or selling of options, futures, commodities, or derivatives with a custodial account.

These investment types might be high-risk, high reward vehicles, but think about it: a custodial account is a tool to save for a child’s future.

This typically isn’t the type of investment you want to gamble with — it should be a sure thing.

Custodial accounts vs 529 accounts: what's the difference?

One of the biggest and most common life expenses young adults face is paying for college.

The average college tuition and fees for 2020 have now risen to more than $41,000 per year for private colleges and more than $26,800 for out-of-state public universities.

Even if financial aid is an option, you may want to start saving now if you’re confident the child in your life is going to be headed off to higher education.

There are a couple of savings options parents or other relatives go for when saving for future college tuition fees, and two of the most common are custodial accounts and 529 plans.

So, what's the difference between a custodial account and a 529?

Here’s a few key areas to consider:

How the money can be spent

A custodial account can be used for whatever the child wants once they've reached a certain age, whether that’s traveling, starting a family, buying their first house, going to college, or something else. 

A 529 plan is a college savings plan that lets parents fund their children's future college expenses. It’s specifically designed for educational expenses. A 529 plan restricts students on how they spend the money their parent, guardian, or loved one has saved.

The assets that you place into a 529 plan can only be used for qualified educational expenses that are required for enrollment or attendance at an eligible college or university.

A qualified expense generally means tuition fees, books and course-related supplies. 

Sometimes, a 529 plan can also be used to pay for room and board. But not all states or service providers allow you to use 529 assets for accommodation, and some plans may be limited to university-managed accommodation.

That essentially means your child has to stay in the dorms if money in the 529 is going to be used to help with living expenses.

How the money is taxed

Another key difference between 529s and custodial accounts is how the contributions are taxed.

Cash placed in a 529 plan typically accumulates on a tax-deferred basis and distributions are tax-free as long as they're being spent on qualified higher education expenses. Contributions made on custodial accounts aren't tax-free.

UGMA and UTMA accounts aren't tax-deferred assets, and so all gains on things like investment properties (if applicable) are taxed as normal.

When does a custodial account make more sense as an investment vehicle than a 529?

The tax savings often make a 529 appear to be the more attractive plan. But what happens if the child you’re investing the money in doesn’t go to college? 

If your loved one turns of age and decides that’s not the right path for them, they’re going to have a difficult time accessing any of the money in a 529 account without paying hefty fees. 

Not only will the funds be taxed, there’ll also be a 10% penalty for spending their money on ‘non-qualified’ expenses. 

A custodial account like an UGMA will always make more sense than a 529 if what you're after is flexibility.

If you opt for a custodial account, your child can use the cash you've saved for a range of other expenses that 529s don't allow for.

That means stocking the fridge, travel money to come visit home as often as they'd like, cash to spend on entertainment at the weekends, and anything in between.

More important still, custodial accounts don't have rules on the sort of institutions your child has the freedom to study at.

For example, if your kid wants to skip college and go into a trade or a cookery school that isn't on a state-approved list of institutions, a 529 won't cover it. 

And if your child decides college isn’t right for them and they’d rather go straight to something else, a 529 wouldn’t be able to fund their future.

An UGMA custodial account would.

That being said, some parents, guardians, and relatives go for both.

By pairing together a 529 and a custodial account, you can benefit from the tax savings of a 529 while simultaneously saving for all of those pesky extra expenses your child may encounter in college that a 529 won't pay out for.

What are the rules for custodial accounts?

Custodial accounts are super flexible investment tools, but even flexible tools have rules that you've got to follow.

Here are a few requirements you need to bear in mind before hopping in the deep end and setting up a custodial account:

Gift tax exemptions

Legally speaking, the contributions that you make to both 529 accounts and custodial accounts are gifts to the minor beneficiary.

The Internal Revenue Service (IRS) has rules about how much you can contribute before you start paying tax on those gifts.

If you're a parent, you can give each of your children $15,000 per year without having to use up any of your lifetime tax gift exemption. 

If you're saving as a couple, the limit is $30,000. Grandparents are allowed to give the same amounts to each of their children and their grandchildren each year.

You're allowed to give more than this, but if you do it'll use up part of your lifetime gift and estate tax exemption.

Account ownership

The most important ownership rule with a custodial account is that once your child (or the child you're saving for) reaches the age of majority, everything in that account belongs to them.

That age is either 18 or 21 in most states.

Most providers will write to you and the beneficiary of the account just before the ownership transfer happens, which will be automatic.

A bank or account provider will then ask the freshly grown-up beneficiary to convert the account into a non-custodial account.

Keep in mind that you can't transfer money in a custodial account to a different beneficiary.

You should also bear in mind that if you’re the custodian of an account, the account balance will become part of your estate if you die before the assets are passed on to a beneficiary.

That means you may want to include directions in your will as to who should become the account custodian until your child comes of age. 

For example, you might request in your will that your brother or sister becomes the new custodian of your child’s account if you die. That way you’ll know the assets will continue to be well-looked after until your kid comes of age.

Filing taxes

Even though you're in charge of a custodial account for a child, the assets and income in that custodial account still belong to that child.

Simply put: minors that make unearned income (like interest, capital gains, or dividends on investments held in an UGMA) will normally need to file an income tax return with the IRS if they've made above a certain amount.

In 2020, the income threshold for needing to file was $1,100, and the tax rate (if applicable) should be at the beneficiary's tax rate instead of the account owner's rate.

What are the pros and cons of custodial accounts?

Custodial accounts are an incredible way for you to protect a child's future and liberate them from future debts early in life.

But just like any other investment type, custodial accounts come with their own set of pros and cons.

Here are some important points you should know about custodial accounts:

Custodial accounts teach kids about investments

Want to teach children about how to invest and manage money?

An UGMA custodial account is an excellent investment vehicle to teach children how the stock market works and the power of compound interest. 

When kids come of age and inherit all of the money in a 529 for college, they often don't have a clue what to do with it, as they weren’t involved in the savings process along the way.

Custodial accounts enable you to engage and teach the child in your life how different investment options work, how compound interest can help create new opportunities to invest, and how to analyze and select investments. 

Custodial accounts are flexible

Unlike 529 plans and some other investment vehicles, custodial accounts are incredibly flexible regarding what the child can spend the money on.

That means not only will the child be able to spend their money on unqualified education expenses while they're at college, but the money can also be used for other important life events like a down payment on a house, wedding, big cross-country move, and anything in between.

So if they ultimately decide college isn't for them, your investment will still be put to good use and help them establish a successful future.

Custodial accounts don't have a contribution limit

Some investment vehicles (like 529 plans, Coverdell accounts, or other investment account types) have a pretty low contribution limit.

Custodian accounts don't have contribution limits, which means you're free to invest as much in your child's future as humanly possible.

Custodial accounts aren't tax-free

Custodial accounts are flexible and efficient ways to invest, but custodial accounts aren't tax-deferred assets.

That means gains on investments are treated as “unearned income”. But because the IRS considers the minor the custodial account’s owner, unearned income up to a certain point will be taxed at the child’s tax rate (rather than the adult custodian).

You won’t have to pay tax on the first $1,050, and the second $1,050 is taxed at a rate of 10%. Anything unearned income above $2,100 is taxed at the parent’s normal rate.

Conclusion

At the end of the day, there are plenty of investment vehicles out there worth exploring.

But if you want to save for the little ones who are important in your life and keep the assets in that account restriction-free, a custodial account could be the perfect vehicle for you.

Custodial accounts don't have a contribution limit, they can help you teach your young loved ones about how to invest, and they can be used in any way so that the child can spend money on what matters to them.

If you want to maximize your child's savings potential and give them that financial freedom, EarlyBird's UGMA custodial account is a total game-changer.

EarlyBird is the industry's first-ever account that allows multiple donors to gift assets into an account.

That means your parents, siblings, cousins, friends, neighbors, or anybody else can fund your child's future with just a few quick swipes.

Contributing to an EarlyBird custodial account is as fast and simple as paying somebody on Venmo or ordering food on UberEats — but instead of sorting dinner, you're sorting a child's future.

Ready to give your loved one a gift that leaves a lasting impression? Download the EarlyBird app today.

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