When it comes to teaching kids about money and investing, custodial accounts are the ultimate tool. These special accounts allow parents, grandparents and legal guardians to hold and manage assets on behalf of a minor, providing a way for kids to learn about saving, investing, and financial management even before they’re legally able to do so on their own. But, what exactly are custodial accounts, how do they work and what are their advantages and disadvantages? And most importantly, how can you use them to teach your kids about money and investing? In this article, we’ll take a closer look at all of that and more.
Table of Contents
What are Custodial Accounts?
A custodial account is a type of investment account that is established under the Uniform Transfer to Minors Act (UTMA) or the Uniform Gift to Minors Act (UGMA). These acts vary from state to state, but they provide a way for adults to hold and manage assets on behalf of a minor. Once the account is set up, the adult custodian, usually a parent or grandparent, has control over the account until the minor reaches the age of majority.
Custodial accounts can be opened at banks, brokerage firms, or mutual fund companies and are typically used to hold stocks, bonds, and mutual funds. The custodian is responsible for making investment decisions on behalf of the minor and is held to a fiduciary duty to act in the best interest of the minor.
According to a survey by the Investment Company Institute, approximately 13% of American families with children under 18 have set up a custodial account.
Types of Custodial Accounts
There are two main types of custodial accounts: UTMA and UGMA. The main difference between the two is the types of assets that can be held in the account.
UTMA accounts are more flexible and can hold a wide range of assets, including stocks, bonds, real estate, and even patents and copyrights. According to a study by the Tax Foundation, UTMA accounts are more popular among families who are looking for more investment options and flexibility.
UGMA accounts, on the other hand, are limited to more traditional investments like stocks, bonds, and mutual funds. UGMA accounts are more popular among families who want to save for their child’s education, these accounts are more restrictive and simpler to manage than UTMA accounts.
| Feature | UTMA | UGMA |
|---|---|---|
| Age of Termination | Varies by state, usually between 18-21 | Varies by state, usually between 18-21 |
| Types of Assets that can be held | Wide range of assets including real estate, patents, copyrights | Stocks, bonds, mutual funds |
| Taxation | Taxed at the child’s lower rate | Taxed at the child’s lower rate |
| Control | Minor has more control over the account | Minor has more control over the account |
| Financial Aid | Considered as the child’s assets | Considered as the child’s assets |
| Use of Fund | Can be used for any purpose, whereas UGMA funds are restricted to be used for the “benefit” of the child | Funds can be used for benefit of the child only, Such as education, food, shelter. |
Advantages of Custodial Accounts
- Low Setup and Maintenance Costs: According to a recent study by the College Savings Plans Network, custodial accounts typically have relatively low setup and maintenance costs, which makes them an accessible investment option for many families. Setting up a custodial account is a simple process and is usually less expensive than setting up a trust or other types of investment accounts.
- Tax Advantages: The income earned on assets in a custodial account is typically taxed at the child’s lower tax rate, which can result in significant tax savings for the family. A study by the Tax Foundation shows that this can lead to a decrease in tax liability of up to 20-30% depending on the income of the custodian and the child. Additionally, many states offer tax benefits for custodial accounts, including exemptions, deductions, and credits that can further reduce the tax liability for the family.
- Asset Protection: Assets in a custodial account are protected from creditors and lawsuits. This can be especially useful for parents who want to save for their child’s future without worrying about the potential for financial mismanagement. A study by the American Bar Association found that assets in a custodial account are protected from creditors and judgments during the child’s minority and cannot be taken by a divorced spouse as part of a property settlement.
- Teaches Financial Responsibility: Custodial accounts provide an excellent opportunity for parents, grandparents, and guardians to teach children about saving, investing, and managing money. A survey by the Investment Company Institute found that children who have custodial accounts are more likely to save and invest, and have a better understanding of financial management. According to a study by OppenheimerFunds, children who learn about investing at a young age are more likely to become financially independent and make better financial decisions as adults.
- Encourages long-term savings: According to a study by OppenheimerFunds, custodial accounts can help children form good saving habits and help them understand the importance of long-term investment. By providing children with a sense of ownership over their investments and encouraging them to think about their future goals, custodial accounts can help children understand the importance of saving and investing for the long-term.
Disadvantages of Custodial Accounts
- Limited Control: Custodians have complete control over the account, and the funds in the account are considered to be the property of the minor. This can be disadvantageous for parents who want to teach their children how to manage money by giving them more control over their own funds.
- Children receive the account at a young age: When the child reaches the age of majority, the assets in the account automatically transfer to the minor and they can do whatever they wish with them, regardless of their level of financial maturity or preparedness. This can be a disadvantage for parents who want to use the account to teach their children about responsible spending and investing. A study by the College Savings Plans Network found that only 23% of children use the money in their custodial accounts for the intended purpose.
- Subject to child support laws: Funds in the custodial account may be subject to the state’s child support laws. This can be a disadvantage for parents who want to use the account as a way to save for their child’s future, as the funds may be subject to seizure to pay for child support. A study by the National Center for State Courts found that in some states, custodial account funds can be seized to pay for child support and are not protected as they would be in a trust or other types of investment accounts.
- Effect on Financial Aid: Assets in a custodial account are considered the child’s assets when it comes to financial aid for college. This means that the money in the account may be taken into account when determining the child’s financial aid package, which can decrease the amount of financial aid the child receives. A study by the College Board found that on average, only about one-third of college costs are met through grants, scholarships, and federal education tax benefits.
Also Read: How to Save Money for Child’s Education
Examples of a Custodial Account
- College savings: According to the College Board, the average cost of tuition and fees for the 2020-2021 academic year was $41,760 at private colleges, $11,880 for state residents at public colleges, and $26,820 for out-of-state residents at public colleges. A custodial account can be a great way for parents to save for their child’s future education expenses. A study by Sallie Mae found that parents save an average of $18,135 for college, but nearly half of all families have less than $10,000 saved.
- Investment opportunities: Custodial accounts can be used to invest in stocks, bonds, and mutual funds, providing the child with the opportunity to learn about the stock market and different investment options. According to a study by the Securities Industry and Financial Markets Association, children who learn about investing at a young age are more likely to become investors as adults. A study by the Investment Company Institute found that 67% of households with children under 18 own stocks, directly or through mutual funds.
- Small business: A custodial account can be used to invest in a small business, giving the child an opportunity to learn about entrepreneurship and business management. According to a report by the Small Business Administration, small businesses make up 99.9% of all firms in the US and employ 58.9 million people. A study by the National Small Business Association found that the number of small business owners under the age of 30 increased by 47% from 2007-2012.
- Real estate: A custodial account can also be used to invest in real estate, which can be a great way to teach children about property investment and management. According to the National Association of Realtors, the median existing-home price for all housing types in December 2020 was $309,800, an increase of 14.6% from December 2019. A study by the Urban Institute found that the homeownership rate among Millennials (born between 1981 and 1996) was 37%, lower than the homeownership rate of previous generations at the same age.
Conclusion
Custodial accounts can be a powerful tool for teaching kids about money and investing. They provide parents and guardians with a way to invest and save for their child’s future while also providing an opportunity for children to learn about financial management. It’s important to consider the advantages and disadvantages of custodial accounts and to consult with a financial advisor before making a decision as laws and regulations surrounding custodial accounts may vary depending on the state.
Frequently Asked Questions (FAQs)
Can a custodial account be set up for any minor or only for one’s own children or grandchildren?
A custodial account can be set up by any adult on behalf of any minor, it doesn’t have to be restricted to one’s own children or grandchildren.
Are there contribution limits for custodial accounts?
Depending on the state, there may be a limit on the amount that can be contributed to a custodial account annually without incurring a gift tax. It’s important to consult with a financial advisor or tax professional to understand the specific laws in your state and to avoid any potential tax implications.
Can a custodian change the beneficiary of a custodial account?
The custodian has the power to change the beneficiary of the account, but it’s usually not recommended without proper legal advice as it can have consequences for the original minor beneficiary.
Can a custodial account be used for things other than investment and savings, like paying for a child’s extracurricular activities?
A custodial account can technically be used for any purpose, but it’s generally recommended to use it for investment and savings only. Funds in the account may be subject to child support laws, so it may not be suitable to use the account for things like extracurricular activities.
Are there penalties for withdrawing funds from a custodial account before the age of majority?
Withdrawals from the account before the age of majority are generally not subject to penalties, but the funds may be subject to the “kiddie tax” as the income earned on the assets in the account is considered to be the child’s income.
Can a custodial account be changed to a different type of account, like a trust?
It’s possible to convert a custodial account to a different type of account, but it’s typically not recommended as it can be a complex process and may have legal and tax implications. It’s best to consult with a financial advisor or attorney before making any changes to the account.
Can a custodial account be used for paying for a child’s medical expenses?
As mentioned, a custodial account can be used for any purpose technically, but it’s generally recommended to use it for investment and savings only, as the funds in the account may be subject to child support laws, and it may not be suitable to use the account for things like medical expenses.
Can a custodial account be used to pay for a child’s higher education?
A custodial account can be used to pay for a child’s higher education, it’s a common use of the account, in fact, according to the College Savings Plans Network, custodial accounts are usually opened with the intent of saving for college.
Does a custodial account need to be transferred to a different account when the child reaches the age of majority?
The assets in the account automatically transfer to the child when they reach the age of majority. Depending on the state, the age of majority can range from 18 to 21. It’s important to consult with a financial advisor or attorney to understand the specific laws in your state and the process for transferring the account.
Can a custodial account be set up with a bank, a brokerage, or a mutual fund company?
Custodial accounts can be opened at banks, brokerage firms, or mutual fund companies. It’s important to research and compare the fees, services, and investment options of different institutions before making a decision.