We all want to help the next generation live their best lives. And one of the best ways we can do that is by contributing to a child’s financial future.
Investing for kids can have powerful effects because the investments have so many years to grow.
But the rules for investing are a bit different for children. In most cases, children must use a custodial account set up by a parent or loved one who is a legal adult.
But what is a custodial investment account, exactly?
This comprehensive guide will explain everything you need to know about custodial investment accounts:
A custodial investment account is an investment account that is set up by a legal adult on behalf of a child.
The adult becomes the “custodian,” while the child becomes the “beneficiary.”
This setup means that the child technically owns the account and the assets inside of it — but they can’t control the account or use the funds until they are an adult.
The custodian is responsible for managing the account, making investment selections, and generally looking after the child’s account. Once the child reaches the “age of majority” (18 or 21, depending on the state), control of the account is transferred to the child.
Custodial accounts are the main way that loved ones can invest on behalf of children. In most cases, an individual needs to be the age of majority in order to open their own investment account. In most states, that age is 18 — but it’s 21 in a handful of states. Custodial accounts bypass this rule.
There are different styles of custodial accounts (more on this below). Some are general-purpose, like the UGMA account. Others are specifically for college savings, like the 529 account.
“Custodial investment account” is a category rather than a specific account type.
There are actually several different types of custodial accounts. The main options include:
Each account style has the same basic operation: A custodian (adult) opens the account and manages it, and the beneficiary (child) gains control once they become an adult.
Beyond the basics, these accounts can be fairly different in tax treatment and the purpose of the funds in the account. Here’s a more detailed explanation of each custodial account style.
UGMA and UTMA accounts are flexible custodial accounts that can be used for any purpose.
“UGMA” stands for Uniform Gifts to Minors Act.
“UTMA” stands for Uniform Transfers to Minors Act.
The two account types are very similar overall. UGMA accounts are more widely available and are well suited for traditional investments like stocks and bonds. UTMA accounts can also “hold” physical assets, like real estate — but they aren’t available in all states.
Funds contributed to these accounts transfer to the child when they become an adult — and they can use the funds for anything:
Many loved ones prefer the flexibility of these accounts. We can never be sure if a child will want to go to a traditional college — plus, it’s difficult to say what the educational landscape might look like in 10-20 years. While 529s generally lock savings into being used for college, UGMA and UTMA accounts provide versatility.
EarlyBird is the best way to open a UGMA account on behalf of a child. EarlyBird is an investment platform that makes it simple for adults to collectively invest in the children they love. You can open a UGMA account in minutes, invest in a diversified portfolio, and invite family, friends, and loved ones to contribute gifts to the account.
Contributions are subject to gift tax rules. Contributors can avoid gift tax by making contributions of up to $16,000 per year. Contributions larger than this require a tax form but still likely won’t be subject to gift tax due to the generous lifetime exemption.
Earnings in UGMA/UTMA accounts may have favorable tax treatment, as some earnings are taxed at the child’s tax rate (which is often very low, due to low/no income). Taxes may be owed on unearned income from UGMA accounts, which includes dividends, interest, and realized capital gains (profits from selling investments).
The specifics of UGMA account taxes are as follows:
Most UGMA account owners won’t pay any taxes until they withdraw funds. This is because account owners would need a lot of invested assets in order to earn more than $2,200 per year in dividends or taxable distributions.
Taxes will likely be owed when investments are sold, however. When assets are sold, the child (now adult) will likely owe some taxes on the profits the investments have made. These are taxed as either short or long-term capital gains.
529 accounts are designed to be used for the beneficiary’s future education expenses. Funds can be used for college, university, K-12 tuition (up to $10,000), and student loan repayments.
Unlike a standard custodial account, the custodian of a 529 maintains control of the account until the funds are actually withdrawn. There may be tax penalties if funds are used for anything apart from educational expenses (see below).
529s are less versatile than UGMA accounts because they are designed specifically for college savings. They do offer some tax perks, however.
Contributions may be subject to gift tax rules (no tax owed on contributions of up to $16,000 per year).
While money is in the account, no taxes are due on earnings or dividends.
When money is withdrawn, it’s free of federal income tax (and state income tax in many states), and federal capital gains taxes, as long as the funds are used for qualifying educational expenses.
If funds are withdrawn for any other purpose, federal income tax will be owed — and a 10% tax penalty may apply.
A Coverdell Education Savings Account (ESA) is another type of college tuition-focused custodial account that is similar to a 529. It offers tax-free growth as long as funds are used for educational expenses.
Unlike a 529, however, Coverdell ESAs allow for a maximum yearly contribution of $2,000, and are subject to income limits. See a more detailed breakdown in our 529 vs. Coverdell ESA guide.
Keep in mind that Coverdell ESAs have income limits. If the household has combined modified adjusted gross income (MAGI) of more than $190,000, they may not be able to contribute to a Coverdell ESA.
Coverdell ESA taxes
Contributions are limited to $2,000 per beneficiary per year.
Earnings and withdrawals from an ESA are tax-free, as long as they are used for qualifying educational expenses.
Custodial retirement accounts, like custodial Roth IRAs, are designed for retirement savings.
In order to contribute to one of these accounts, the child must have earned income from a job or a business. Allowance money and gifts are considered unearned income and can not be used to contribute to a Roth.
If a child does have earned income, an adult can set up a custodial Roth IRA (or other account) on behalf of the child. The child (or the adult, so long as the child has enough earned income) can contribute up to the amount of earned income each year, to a maximum of $6,000.
Roth IRAs are designed for long-term retirement savings. If funds are withdrawn prior to retirement age, penalties may apply.
Custodial Roth IRA taxes
Contributions are limited to $6,000 max per year, and individuals can only contribute up to the amount of earned income they have for the year.
Withdrawals in retirement are tax-free. All earnings growth is not subject to income tax (as long as the withdrawals are made in retirement).
Early withdrawals may be subject to tax penalties and/or income tax. However, Roth IRAs specifically allow for tax-free withdrawals of any contributions at any time.
For example, if you put in $1,000 and it grows to $2,000, you could withdraw the original $1,000 at any time without paying taxes. But if you withdraw any of the profits, you will owe tax and may also owe a 10% tax penalty.
Because of this withdrawal loophole, some people use Roth IRAs for college savings — but their tax benefits are most powerful when used as a retirement account.
Here are the steps to open a custodial investment account:
The process will look slightly different depending on where you open the account, but the basics will be similar.
Keep in mind that some companies will have a minimum opening deposit and/or a minimum account balance. You may need to deposit some funds at the time of opening.
EarlyBird is an investment platform that makes setting up a custodial account simple. It offers simple yet effective investment choices in an easy-to-use personal finance app.
The EarlyBird app allows adults to set up UGMA custodial accounts in minutes. All you need is your personal information and the beneficiary’s personal information.
EarlyBird is simple to use, with an intuitive app and pre-built investment portfolio options. You can make one-time contributions or set up automatic transfers to contribute on a regular basis.
No investing experience is required. You can choose from a variety of pre-built portfolios that investment experts craft. EarlyBird portfolios include stocks, bonds, ETFs, and even cryptocurrency — and you can customize your approach depending on goals and risk tolerance.
Plus, EarlyBird enables collective investing. Friends, family, grandparents, etc., can all contribute financial gifts directly to the child’s EarlyBird account. Those gifts can be automatically invested in a diversified investment portfolio of stocks, bonds, low-cost index funds, and more.
When someone sends a gift through EarlyBird, they can attach a short video message. This makes it simple to personalize financial gifts, leaving well wishes for the child and enabling impactful gifting. With EarlyBird, you can gift wealth, not waste.
A custodial investment account is the simplest way to invest in the children you love and teach them about investing.
In most cases, a UGMA account is the simplest option. UGMA accounts are flexible because the funds can be used for any purpose.
EarlyBird makes it simple for adults to open custodial investment accounts for children, even if they have zero investing experience.