What is a custodial account? Investment accounts for kids
June 29, 2022 • 6 min read
What we'll cover
What is a custodial brokerage account
Types of accounts that can be opened for kids
Benefits of custodial brokerage accounts
Getting your child off to a good start financially can pay dividends over the long term. Kids who learn about budgeting and saving from an early age tend to have healthier relationships with money as adults.
A custodial brokerage account can be a great way to help children develop lifelong saving habits. But what is a custodial brokerage account, and should you open one? Here’s a closer look at how these brokerage accounts for kids work.
What is a custodial brokerage account?
A custodial brokerage account is an investment account that's opened on behalf of a minor child and managed by an adult. For example, a parent or grandparent can open a custodial account for their child or grandchild.
These accounts can hold the same types of investments that you'd find in a regular brokerage account.
How does a custodial brokerage account work?
Custodial brokerage accounts allow the adult (or the custodian) who opened the account to invest money for the benefit of a child.
While the child is a minor, the custodian can buy or sell investments as they see fit. But a custodian must act in the best interests of the child when making investment decisions — their control over assets in a custodial account isn't unlimited or unchecked. And they don't control the account forever.
Two types of custodial accounts
If you're interested in opening a custodial account, it's important to understand your choices.
You can open a custodial brokerage account at online brokerages like Ally Invest that offer regular brokerage accounts, as well as retirement savings accounts.
However, a custodial account can also be set up as a savings account. Instead of investing money on behalf of a child, you save it and earn interest. You can find custodial savings accounts at FDIC insured banks, including Ally Bank , and credit unions.
Once you decide the type of custodial account, you also must determine whether to open a UTMA or UGMA account:
While the specific requirements for UTMA/UGMA Accounts vary from state to state, the accounts do share common characteristics.
The Uniform Transfers to Minors Act (UTMA)
The Uniform Transfer to Minors Act allows you to hold virtually any type of asset or property in a custodial account. For example, you can use a UTMA to hold stocks, bonds and mutual funds but you could also use it to hold real estate, fine art or even intellectual property.
UTMA accounts do not have annual contribution limits, though gift tax may apply if you're over the annual exclusion limit. For 2023, the gift tax exclusion limit is $17,000 to $34,000 for married couples who split gifts.
Gifts and transfers are irrevocable, so once the money goes into a UTMA you can only spend it for the benefit of the child.
The Uniform Gift to Minors Act (UGMA)
With this type of custodial account, you can hold stocks, mutual funds, bonds and exchange-traded funds (ETFs) . You could also hold cash, certificates of deposit (CDs) or life insurance policies. But you can’t invest in alternative investments the way you can with a UTMA account.
The same gift tax exclusion limits apply to UGMA accounts and gifts are irrevocable.
What are the pros and cons of a custodial account?
Opening a custodial brokerage account may make sense if you want to start investing on behalf of your child. Like any financial decision, it's important to weigh the advantages against any potential drawbacks.
Benefits of a custodial account
Convenience is at the top of the advantages. For instance, child custodial accounts can be easier to set up and maintain than a trust.
They also offer flexibility since you can choose to open a brokerage account or a custodial savings account. With a brokerage account, you also have a variety of investment opportunities, whether you select a UTMA or a UGMA account.
Custodial accounts can be used to invest for specific goals with fewer restrictions. For example, you might use a custodial account to invest for college. Unlike a 529 college savings plan or Coverdell ESA, you're not limited to using the money for education expenses.
Cons of a custodial account
Custodial accounts can add a wrinkle to college planning since assets are the child’s property. Consequently, if your child has a sizable balance in their custodial account, that could affect how much financial aid they're eligible for.
You don't get tax breaks for making contributions to a custodial account, and there can be tax implications for your child when selling any account assets.
Lastly, custodial accounts give adults the ability to make account decisions only until a child comes of age. If after that point you want to continue to maintain control over the investments, you might be better off opening a living trust.
What are the tax benefits of a custodial account?
You can't afford to forget about tax planning when it comes to investing. Investment income generated by a custodial account, including dividends, interest, and earnings, may be classified as the child's income under IRS rules. This means the income is taxed at the child's tax rate, which is likely to be lower than an adults.
The adult who opens the account can get a break on gift tax. For 2023, you can gift up to $17,000 per child as an individual or $34,000 per child if you're married and file jointly without triggering the federal gift tax.
Who pays taxes on custodial brokerage accounts?
Technically, a custodial brokerage account is owned by the child. So, they are responsible for paying taxes on any earnings, not the custodian. If no investment income is earned, no tax is due.
Here's how it works for 2023 if the child is under 18:
The first $1,150 is not taxed
The next $1,150 is taxed at the child's rate
Amounts over $2,500 are taxed at the custodian's rate
What happens to a custodial account when the minor turns 18?
Once the child reaches adulthood (18 to 21 years of age, depending on the state), the assets in the custodial account automatically become theirs. Once the child assumes ownership, they can hold onto the assets, sell them, or transfer them to another account. The person who opened the account no longer has a say.
Can you withdraw money from a custodial account?
Custodians can withdraw money from a custodial account — but only if it’s in the child’s best interests. For example, the money could be used to pay for private school tuition or extracurricular activities.
Generally, you can't use money to pay for anything you're obligated to cover as a parent, like shelter, food, necessary clothing and medical care.
How to open a custodial account at Ally Invest
To open a custodial account with Ally Invest, you first need to choose between a Self-Directed Trading account (where you determine what to investment in), and a Robo Portfolio (where financial professionals and an automated platform will help you select investments based on your goals, risk tolerance and timeframe).
During the account opening process, select custodial account as your account type and complete the remaining steps.
Once your account is approved, don't just set it and forget it. Be sure to update it to balance your risk tolerance and financial goals that connect to important life events .
It's never too early to start investing
A custodial brokerage account can help you raise money smart kids. Start investing when they’re young so they could possibly get ahead financially.
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