Last editedAug 20212 min read
If you’re looking for ways to save for your child’s future, you might be interested in a custodial account. We’ll break down how this type of savings account works below, as well as discuss the advantages and disadvantages that a custodial account comes attached with.
Custodial accounts explained
The term can refer to any savings account managed on behalf of an account beneficiary. For example, if an employer administers retirement savings accounts on behalf of its employees, these will qualify as custodial accounts.
However, in most cases this term is used to refer specifically to savings accounts controlled by an adult on behalf of a minor. These can be opened at banks, brokerage firms, or mutual fund companies depending on the type of account. For example, a brokerage firm would typically handle a custodial stock account. The account’s custodian serves as a manager to approve transactions until the minor reaches the appropriate age, defined as either 18 or 21 depending on individual state laws.
The account is considered the minor’s asset and is transferred solely into their name at adulthood. Custodial accounts can be used to save for the child’s future, offer a financial gift, or invest in mutual funds, stocks, and bonds.
How custodial accounts work
Although it’s structured a bit differently, a custodial account is managed as any other investment or savings account would be. The designed manager, or custodian, decides which securities to invest in. The account manager can contribute cash into the account at the same time.
A custodial account can be invested in stocks, bonds, and funds, but it usually won’t be used to invest in riskier assets like futures and derivatives. Once the minor has reached legal adulthood, they retain complete control of the account and can use the funds as they like.
Types of custodial accounts
There are two primary types of custodial accounts, including the Uniform Transfers to Minors Act (UTMA) and Uniform Gift to Minors Act (UGMA) varieties.
UTMA accounts can be used to hold any type of asset, including stocks, bonds, mutual funds, real estate, intellectual property, and fine art.
UGMA accounts are more limited, restricted to financial assets such as cash, securities, annuities, and insurance policies.
While UGMA accounts are allowed in all 50 states, UTMA accounts can be opened in all states apart from South Carolina.
How to open a custodial account
Once you’ve compared your options and selected a bank account provider, the procedure for opening a custodial account is straightforward. Here’s how to open a custodial account:
Visit the bank or broker’s website to compare products.
Look at the payment and contribution structure, interest rate, and fees.
Fill out an online application or visit the broker in-person.
Provide requested identification documents (such as passport or Social Security card).
Pros and cons of a custodial investment account
There are distinct advantages and disadvantages which are important to consider before opening a custodial stock account.
Advantages of custodial accounts include their flexibility. You can contribute as much as you like without any limit, and there are no penalties for early withdrawal. Withdrawn funds must be used for the benefit of the beneficiary or minor, but this could include everything from clothing to education. There are also a few tax advantages to opening a custodial account. Because the minor child is the account’s owner, account earnings are taxed at a child’s rate. This means that the first $1,100 of unearned income is tax-free.
However, a custodial account won’t be right for everyone. One of the major factors to consider is that because it qualifies as the minor’s asset, it will be weighed into the equation when applying for financial aid. Although there are tax advantages, a custodial account isn’t as protected as some other accounts.
It’s worth weighing these pros and cons carefully before determining whether a custodial account is right for your family’s financial situation.
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