One of the greatest gifts you can give a child is financial freedom.
By investing for the kids you love now, you’ll be able to open up all sorts of doors for their financial future. You can protect them from having to take out crippling college loans and help them start a business, get on the housing ladder, travel the world, or anything in between.
But there are a lot of investment vehicles out there to choose from. Two of the most popular vehicles are trusts or UGMA custodial accounts — and they both come with their own sets of pros and cons.
This guide explains how a trust works, how a UGMA custodial account works, and what the differences are between a trust and a custodial account.
How Does a Trust Work?
You’ve probably heard a lot of references to “trust funds” in pop culture — and the way they work is pretty simple.
Simply put, a trust is a legal agreement that ensures assets are held and set aside for somebody to receive later. It’s important to know that the person who’s going to receive the assets doesn’t have control over the trust fund.
In a basic trust, there are usually three roles: the grantor, beneficiary, and trustee.
The grantor is the person who created the trust. If this is done while the grantor is alive, the fund is a living trust (or “inter vivos”). The grantor will then fund the trust over a period of time. The grantor can use a trust to hold assets like cash, securities, real estate, and other valuable items.
The beneficiary is the person to who the trust will provide those assets. A trust can have multiple beneficiaries or just one. It depends on the wishes of the grantor and how the trust is designed.
Finally, there’s the trustee. A trustee is responsible for ensuring the trust fund documents are laid out according to any applicable laws. Trustees also ensure that the assets in the fund are held and allocated according to the grantor’s wishes.
A trust fund can have multiple trustees, and a trustee can be a single person, a company, or an institution.
Some trust fund providers also offer professional trustees if you don’t wish to appoint someone you know. Trustees are usually paid a small management fee, and some trust funds allow trustees to manage the trust assets in a fund.
Other trust funds require the trustee to appoint a qualified investment advisor to handle the investments in an account.
Trust funds are most commonly used by an individual that wants to pass assets on to their loved ones — but wants that handover to happen at a specific time or under a specific set of conditions.
For example, let's say you want to leave money to your grandchildren, but you’re concerned about them blowing all the money too quickly. You could put assets into a trust and then say that your grandchildren can't access any funds until they each reach the age of 30.
Alternatively, you could specify in your trust that the cash you’ve set aside for your grandkids can only be used to pay for college or higher education. The trustees will then make sure your wishes are upheld.
That flexibility is a major benefit of setting up a trust fund. Trusts enable you to decide how and when assets get transferred — and as long as you stay within the parameters of the law, you have a lot of options.
But the biggest drawback of trusts is that they can end up costing more than other investment vehicles.
Setting up and managing a trust requires quite a bit of time and effort. There will also be set-up fees, and if you hire a professional trustee, you’ll likely need to pay them management fees.
How Does a UGMA Account Work?
An increasingly popular alternative to the traditional trust fund is a Uniform Gift to Minors Act (UGMA) custodial account.
The UGMA custodial account is named after the legislation that created it, and it’s a dynamic investment vehicle that allows an adult to save assets for a child to access and spend when they reach a certain age.
When you set up a custodial account as an adult, you’ll appoint a child beneficiary. Because the child is too young to manage investments, you’re responsible for managing all of the assets in your UGMA account as its custodian.
But once the child reaches the age of majority in their state, the custodianship will end, and all of the assets will pass onto the (now adult) beneficiary. In most states, the UGMA age of majority is either 18 or 21.
Custodial accounts have some really useful benefits.
First, there’s a tax benefit to consider.
The adult custodian is the one responsible for placing assets into the account and managing those assets. Everything in the custodial account still counts as the legal property of the child beneficiary.
That means if the account generates any unearned income through compound interest, that income will be taxed at the child’s lower tax rate (up to a certain point).
UGMA custodial accounts are also popular ways to save for a child’s financial future because they don’t have any contribution limits. That empowers you to save up as much as you want for the kids in your life without having to worry about breaking any rules on contribution limits.
Finally, custodial accounts give the kids you’re saving for a lot of flexibility in terms of how they use the assets you’re saving for them.
After a child beneficiary reaches the age of majority, they can use the assets in their custodial account however they wish. If you’d set up a rigid trust fund with specific allocation conditions, they won’t have this flexibility.
For example, you could specify that a child must use their trust fund to pay for their dream wedding — but the child might grow up and not even want to get married.
You can’t always predict how the lives of your loved ones are going to turn out, and so it’s worth thinking carefully before you lock up any funds on a conditional basis.
Trust or UGMA: How to Choose the Best Account For Your Loved Ones
Trusts and custodial accounts are really similar in terms of purpose. Both accounts are investment vehicles that an adult can use to set aside assets they want to give a minor beneficiary at a future date.
But there are a couple of key differences to consider — and how much weight you place on those differences will ultimately decide which account is right for you and the kids in your life.
First, think about how much control you want over the assets you’re saving.
Trusts are managed by trustees. This means that once you set up the trust and start to fund it, full control over how those assets are invested or allocated is going to be someone else’s responsibility.
By contrast, custodial accounts are managed by you as the adult custodian. That means you’ll probably have a bit more control over how your nest egg grows over time with a UGMA account.
But if you don’t want that responsibility and don’t mind handing over control to a third party, a trust might work great for you.
Next, you should consider how and when you want assets transferred to your beneficiaries.
If you decide to set up a trust fund for a child, you can specify a transfer of assets to take place at just about any age you want. You could specify they get access to funds when they’re 18, 21, 35, or any other age. You’re in full control.
You can even select life events or points in time when you want a transfer to take place. For example, you could elect to give the beneficiary assets after they graduate from college or get married.
With a UGMA custodial account, the transfer of assets is a lot more straightforward. As soon as the child you’ve appointed as your beneficiary reaches the age of majority in their state, the custodianship has to end.
The age of majority is slightly different in each state — but generally speaking, it’s usually going to be either age 18 or 21.
This means you’re not allowed to set specific parameters around how or when the child gets access to their nest egg, but it can make things a lot simpler and more convenient for the beneficiary you’ve been saving for.
After weighing the pros and cons of each account type and what’s important to you, it should hopefully be a lot simpler to make a decision. But if you’re genuinely struggling, don’t be afraid to ask for professional advice.
After all, it’s important to know what you’re getting into before you choose an investment vehicle — particularly because setting up a trust can be costly and time-consuming. That’s why you need to do research in advance.
Trusts and UGMA custodial accounts are both designed to do a similar job: to build wealth for your loved ones to use in the future. But the rules and how they’re used in practice are different.
That’s why you need to think hard about what it is you’re looking for in an investment vehicle. Consider why you’re saving, who you’re saving for, your investment style, and what your beneficiaries will want.
You may ultimately decide a trust is right for you. But a custodial account will generally offer an easier and more affordable way to save for the kids you love — and so it’s definitely worth checking out EarlyBird.
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This page contains general information and does not contain financial advice. All investments involve risk. Any hypothetical performance shown is for illustrative purposes only. Actual investment performance may be different for many reasons, including, but not limited to, market fluctuations, time horizon, taxes, and fees. Please consult a qualified financial advisor and/or tax professional for investment guidance.