An Overview Of Custodial Accounts And How They Work

Let’s talk about saving money for your child via custodial accounts and education plans. Different types of custodial accounts for minors can help you save for your child’s future. Here’s how they work!

How custodial accounts work

Parent-owned custodial accounts for minors are a great way to pass on generational wealth to your children or grandchildren.

In addition to being useful for education, custodial accounts have multiple purposes, from college to wealth building. A child’s parent or a grandparent is most likely the person who will set up a custodial account.

College is obviously a large expense, and custodial accounts and 529b plans may be the answer. Parents are making saving a priority.

The Saving For College survey found that 40% of parents had saved up over $30,000 for their kid’s college. However, only 7% of parents feel that they have enough money saved up for college costs.

What is a custodial account?

A custodial account is fairly easy to figure out. It’s simply an investment account that an adult controls for minors who are under the age of majority, which is 18 (in some states, 21).

In my custodial accounts, I can invest funds in the stock market for the financial goals I have set. Saving for my children’s college student education is one of them.

There are a few very important factors to keep in mind with custodial accounts for minors. They include the following:

Your child might need to pay taxes on any income the account makes

Income from interest, dividends, or capital gains, may need to be included in your tax returns or your child’s tax returns. (It’s best to clarify this with a qualified tax accountant.)

There are tax rules around monetary gifts you give your child

The rules are complicated surrounding gift taxes. You may be able to give away a certain amount of money a year as a gift, such as 18,000, without paying taxes.

However, there are many rules that apply, and asking an accountant is the best course of action.

The money does not have to be used for college

A big advantage of the custodial brokerage account is that the beneficiary can use this money for anything. It’s not directly tied to your child’s education.

It also means that it isn’t limited to just tuition and fees like college savings plans. But do keep in mind that this could also impact financial aid eligibility for your child.

Types of custodial accounts for minors

There are a few types of custodial accounts that you can choose from. Choose the one that works best for you and makes the most sense for your financial situation.

Uniform Gift to Minors Act

With a UGMA, the custodian can make investment choices and put the money in bonds, stocks, mutual funds, ETFs, and other investing options. It can be very beneficial if you’re saving up for large future expenses.

Withdrawals need to be for the minor the account is for

A great feature about these is you have the ability to make a withdrawal of money from this account, as long as it benefits the minor the account is for. Which may come in handy to pay for education before college or other expenses for your child.

No formal trust is required

A main advantage of UGMA accounts is that you don’t need to set up a formal trust. You can use the money you deposit in this account to invest in your child’s future, and they are simple to set up.

Not tax-deferred

An important thing to note is that this type of account isn’t tax-sheltered, which may affect your decision.

Uniform Transfers to Minors Act

UTMA accounts are quite similar to the UGMA. The one major difference that you’ll notice is what makes up the account. 

Property can be part of the account

The UTMA can include property. You can give real estate, jewelry, and other items to the beneficiary of the account. It’s a good option if you have property or assets like a car or a home and you want to someday transfer ownership to your kid.

Not tax-deferred

As with a UGMA, the UTMA is also not tax-deferred.

Education savings accounts

There are a couple of options for savings accounts, specifically for education. Here’s what you need to know.

529b plan

With a 529b plan, you can set aside funds for your child’s future college student budget expenses, i.e., tuition, books, and other educational costs. These funds can only be used at accredited 2 or 4-year colleges, vocational and technical schools, or at eligible foreign colleges.

Unlike custodial accounts, there are contribution limits with the 529 plans. Contribution limits are typically between $300,000 and $500,000 depending on the state.

529b’s are typically set up by the state, but you can open a 529b in a state different from your primary residence. Some states offer special tax deductions if you open a 529b in the state where you live.

That said, you want to make sure you are aware of all restrictions on the account, including where your child can attend college. You also want to be aware of the fees and costs you will be paying compared to the tax deduction you will get. Here are some of the benefits of a 529b account to help you answer the question, “Is a 529 plan worth it?”

Money grows tax-deferred

The main benefit of having a 529b in place for your child is the tax benefit. Once you begin making contributions, your earnings can grow tax-deferred. Those distributions will not be taxed by the federal government if you use the money for qualified education expenses (which is the purpose of the 529b).  

Withdrawals can be made at anytime

You may take money out of a 529b at any time for any reason. However, if you don’t use the money towards your child’s college education costs, then you will have to pay income taxes and also a 10% federal tax penalty.

The money is invested

Since the 529b is a state-sponsored program, your money is typically invested on your behalf by established brokerage firms. You can open your 529b account in various funds and pick what plan works best with your objectives for your child’s college savings.

One of the most popular approaches for how to start investing for college is selecting funds based on the age of your child.

One approach starts out investing more aggressively, but as your child approaches college age, the mix of investments gets more conservative, i.e., more money in cash and bonds vs. funds.

Alternatively, you can create your own investment mix from the brokerage firm’s available portfolios in their 529b plans.

Remember, with a 529b plan, the money still belongs to you, whereas with a custodial account, the funds belong to the child.

My story with 529b plans

As a mom to twins, one of my financial goals is to support my kids when they go to college. To achieve that goal, I have put a couple of things in place to support this plan.

They include splitting up the college savings for each of my children between custodial brokerage accounts and 529b plans.

For example, I chose the New Hampshire 529b plan, although I live in New Jersey. At the time of writing this, my state does not offer any sort of tax deduction or incentive around the 529b.

However, under the New Hampshire plan, my kids can go to college anywhere in the country.

About 33% of families are saving for college using 529 plans or other college savings plans. They are great educational resources. A state or state agency sponsors these plans and provides tax-advantaged savings.

Almost every state has at least one plan, and you can even opt into an out-of-state one if you’d like.

Coverdell Education Savings Account (ESA)

A Coverdell ESA can help you pay for educational expenses for your child, including more than just college.

Covers elementary through high school

You can also pay for other educational costs from elementary through high school using this type of account. 

It may come in handy to fund an account like this, especially if you plan on sending your child to expensive private schools or if you think their education costs will be high even before college.

Tax-free distributions

Distributions to a Coverdell Education Savings Account are tax-free as long as they do not surpass the beneficiary’s qualified education expenses. The distributions can be used for expenses like tuition and fees, as well as for a computer, books, and other school supplies.

Similar to a 529b you can open an ESA with a brokerage firm and your contributions are invested. You can find more contribution information on the IRS website.

Expert tip

There isn’t one perfect solution for saving for your child’s future. Consider options for education e.g. scholarships and grants, as well as other ways to save e.g. looking at 2-year vs. 4-year colleges.

Communicate with your family and your kids about these financial decisions so they know what to expect and how to prepare for this money when the time comes.

Best custodial accounts for minors

If you don’t know where to begin looking for the right accounts, here are some of the best custodial accounts for minors from reputable companies.

The above options all offer a simple process to transfer ownership of the account to your child. There are also lots of investment options including ETFs and mutual funds. And very importantly, you can manage the accounts from your mobile device.

Other options to save for your child’s future

There are a couple of other options if you want to go another route with saving.

Custodial 529 plan

A custodial 529 plan is a combination of a 529 plan and a custodial account. But the child is both the beneficiary and the account holder. It can help you save for college and other big expenses for your kid’s future.

Prepaid tuition plan

Prepaid tuition works similarly to a credit system. You essentially prepay future tuition and fees at today’s costs.

The stipulations set by the plan you have (e.g., covers tuition for only a specific university) limit your funds. These are becoming less common.

Joint savings accounts

A joint savings account is a great opportunity to start saving up money and also teach your children about how finances work. Your kid can have a supervised bank account, so you are aware of all spending.

You may also open a checking account for your child, depending on what you want to use the money for.

It’s a simpler option if you want to start teaching your kids about money and you’d like to begin saving for their future, but you aren’t ready to commit to a custodian or 529b account yet.

Roth IRA for Kids

Want to help your kid prepare for retirement early? Everyone knows that the more time an investment has to grow, the more money you can potentially make. 

Roth IRAs give you the opportunity to save for your child’s retirement tax-free. While it may seem like retirement is a bit too far in the future, this can be an excellent way to help your child build wealth over time.

What is better 529 or a custodial account?

A 529 is a great option for education. But the other hand, a custodial account for minors helps with education, as well as other purposes.

Your kid may use the money for various things, such as purchasing a home. Or they can avoid finding out how to start a business with no money by using the savings from their custodial account.

So there is more flexibility with a custodial account, but if you’re sure that college is in your child’s future, a 529 also works. If you’re still unsure, consider consulting a financial advisor.

Are custodial accounts a good idea?

A custodial account may be a smart way to pass on generational wealth and help your child with college and educational expenses.

However, to determine if it’s the right choice for you, you need to look at your own financial situation.

First, are your finances in a good place for you to start investing for your child’s future? Do you have emergency savings and retirement savings? If so, and you have the means to add money to an account for your child, custodial accounts for minors can be a good idea.

However, also remember that the money will be your child’s once it is added to the account. You will no longer be able to use the money for anything, so be sure that you can afford this first.

Can parents take money from custodial accounts?

Any money transferred into a custodial account now belongs to your child, and you are essentially the custodial manager.

Meaning legally, you can only use the funds in this account for expenditures that benefit your child, not yourself. You cannot withdraw this money and use it for whatever you want.

Should you open a custodial account for your child?

It’s a personal choice that has to do with your budget and finances, as well as your child’s plans for the future. You may prefer a custodial account if your kid is undecided about going to college or if you’d like the option to pay for more things than just education.

In addition, custodial accounts are a good idea if you plan on giving your child any sort of property like real estate.

What happens to custodial accounts after 18?

Once your child reaches age 18 or age 21, they are no longer a minor and will gain full control of the account.

The specific age of 18 or 21, when your child is no longer a minor, depends on the state you live in. That said, it’s important to start teaching your children financial responsibility as early as possible.

Topics like how to manage credit card debt and balancing school and work as a college student are key lessons you can teach your child for their financial success!

Save for your child’s future starting today!

As college expenses continue to rise, it’s important to take steps today with custodial accounts for minors or educational savings accounts to help your child get an education without worrying about the debt burden of how student loans work.

If you are a new mom or preparing for a baby, it’s not too early to start. And if you’re years behind, don’t worry; it’s never too late, either.

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