The magic ingredient that makes investing so powerful is compounding interest.
Your returns build returns of their own, which then build even more returns. It’s like a snowball rolling downhill.
The earlier you invest, the bigger that snowball will get — which is why many parents and other adults love custodial accounts. These accounts help children build assets and generational wealth early and for a long time.
But just because the child in your life isn’t an adult yet doesn’t mean there aren’t tax consequences associated with custodial accounts.
Below, we’ll clarify who pays taxes on custodial account growth and explore a couple of other tax issues you should keep in mind.
A custodial account is a type of investment account that one person sets up for someone else’s benefit. That “someone else” is called the beneficiary.
There are two broad types:
UGMAs and UTMAs are quite similar, but they do have a few differences, including:
In both cases, the person who sets up the account — the custodian — has a fiduciary duty to the account beneficiary, meaning they must act in the beneficiary’s best interest.
So, any investments they make must be for the beneficiary’s benefit — not their own.
Custodial accounts are most commonly used by parents or guardians that want to give their children a head start on financial goals, such as buying a house, getting married, or going to college.
But, grandparents, aunts and uncles, and other family members or friends can also set up and contribute to a custodial account for a child.
Unlike savings accounts, custodial accounts can be used to purchase investments like stocks and bonds. This means that the beneficiary of the account could earn much higher returns, depending on market performance.
Custodial accounts are often an attractive option because of their flexibility.
When the beneficiary comes of age, they can use the funds however they’d like, unlike a 529 plan, which requires the child to use the funds for educational expenses.
The most confusing part for many adults who open up a custodial account is the taxes.
Who pays taxes and whose tax bracket applies when the adult manages the account, but the account belongs to the kid?
We’ll cover that next.
The child beneficiary technically owns the custodial account — not the custodian. It’s the beneficiary's Social Security number that is attached to the account.
Thus, the child is the one who technically needs to pay taxes. But, it’s not as simple as it sounds.
First of all, a specific amount of the child's income is exempt from federal income tax. The exempt amount increases most years to adjust for inflation, so make sure you check how much qualifies each year.
For the tax year 2021, the child’s first $1,100 of unearned income is tax-free.
The next $1,100 is taxed at the child's tax rate. This is likely to be minimal — in the 10% or 12% brackets — since most minors don’t earn a substantial income.
Finally, any unearned income the child makes in this account beyond $2,200 is taxed at the parent’s or guardian’s tax rate.
This tax rule is known as the Kiddie Tax.
The IRS created the Kiddie Tax to prevent parents from placing assets in their children’s names to avoid taxes. It applies to children 19 or younger or full-time dependent students under 23.
Let’s illustrate each possible tax scenario with some quick examples:
It’s important to note these taxes only relate to unearned income. That means the child is only taxed on realized gains from selling an asset or investment income, such as bond interest or dividends — money deposited into the account isn’t taxed.
If they don’t earn any investment income or realize any capital gains, they won’t owe taxes.
Children can also take capital losses — when they sell an asset such as stock for less than they bought it for. These losses can be used to offset gains and reduce unearned income on their current or future returns.
Generally, a tax return would need to be filed on behalf of the child by their legal representative (typically their parent or guardian).
However, under certain circumstances, the parent or guardian can report a child’s unearned income on their own tax return by filing Form 8814.
For this option to be possible, the following must be true:
There are a couple of other tax concerns to think about when managing a child’s custodial account.
These deal with gifting the child money for their account and yearly contribution limits.
Let’s look at both these issues.
The federal government charges a gift tax on money or property you transfer to someone else without receiving the equivalent value in return.
This applies to giving a child money as a gift to invest within their custodial account.
Luckily, the exemption amount is high — in 2021, you can give up to $15,000 to a child’s account without having to file a gift tax return.
You also have a lifetime exclusion amount of $11.7 million for 2021, which generally increases every year for inflation.
If you give more than $15,000 to one child during 2021, you must file IRS Form 709, the gift tax return. The IRS deducts any amount above $15,000 from your lifetime exclusion amount.
For example, if you gave the child in your life $18,000 this year, you’d deduct $3,000 from your lifetime exclusion amount.
That said, you won’t owe any gift taxes until you exhaust your entire lifetime exclusion amount and you gift someone more than $15,000 in a year.
For instance, you could exceed your lifetime amount and still gift the beneficiary $14,000 per year without filing a gift tax return or paying any gift taxes.
In most cases, a child can receive a significant amount of donations to their custodial account each year from parents, relatives, or other people without anyone worrying about gift taxes.
Custodial accounts don’t have a contribution limit. Custodians, beneficiaries, and relatives can contribute as much as they’d like without penalties.
Again, keep in mind gift tax amounts when contributing to the child’s account.
Opening a custodial account for the child in your life can be an excellent way to set them up for future financial success. But, as with anything related to money, you must consider the tax consequences.
You may owe taxes at both your rate and the child’s, and they might even have to file a tax return.
The most important thing for custodians to do is keep track of the account’s profits and your own gifts so you know what needs to be reported at tax time and you don’t run into any tax issues later.
Visit EarlyBird to learn more about how you can invest in the children you love.