Custodial Accounts: Worth the Hassle?

You have a child, and want to build up savings for them. Do you go for a tax-deferred plan, like a 529 Plan or Coverdell ESA? Or do you set up a custodial plan, a taxable plan that you control in their name? Or do you set up both?

You do a little research on custodial accounts, and see some advantages: you can put a wide variety of assets in a custodial plan, and it can be used for any expense in the child’s benefit without tax penalties. You aren’t stuck choosing from mutual funds you don’t love that may have limited upside. You won’t have to worry about whether an expense is a qualified educational expense.

But there are serious disadvantages to custodial accounts:

  • You can’t take the money back or transfer it to anyone else once it is in a custodial account. Unlike 529 plans, you can’t transfer a custodial plan to a different family member.
  • Your child will get control of the account when they reach their legal majority, usually between the ages of 18-21.
  • Custodial accounts may reduce your child’s eligibility for financial assets, because after the first $3000, student assets count 20% in the FINRA calculation while parent assets only count 6%.
  • Taxes! Unless your child’s unearned income falls below $1050 or you can report all of their unearned income through an election to report interest and dividends, you will have to file a tax return for your child.
  • More Taxes! The Kiddie Tax means their unearned income will be taxed at your highest federal tax rate once it exceeds $2100, rather than at the lower rates your kid’s income would indicate.

So, the kid gets the money while they are still basically a kid, loses some financial aid eligibility, and may have to pay additional taxes. Why is that a good idea?

So you can teach them about investing.

A Little Background on Custodial Accounts

Custodial accounts are set up by rules based on either the Uniform Gift to Minors Act (UGMA) or the Uniform Transfer to Minors Act (UTMA). Each of the 50 states and the District of Columbia follows either UGMA or UTMA, with all but South Carolina and Vermont choosing to follow UTMA. Whether you set up an UGMA or UTMA account depends on the state where you set up the account.

UGMA is the older law, set up in 1956. UTMA was introduced in 1986 to add more flexibility in terms of usage and investments. The basic structure is the same. The account is owned by a minor but an adult custodian controls the account until the minor reaches legal majority. The minor has tax liability for any income over a certain amount, which changes year to year. The basic differences are:

  • Asset Selection: UGMA allows investment in bank deposits, insurance policies and securities. UTMA allows for a broader range of investments, including real property
  • Usage: UGMA accounts may be used for the child’s support. UTMA accounts have broader usage.

A custodial account doesn’t have to be huge, but opening one may be more expensive than opening a 529 plan, and vary widely between providers. For instance, at Charles Schwab, the account minimum for a 529 plan is $25, while the minimum for a custodial account is $100. At Fidelity, however, you can open a 529 plan for $15 a month or $50, while a custodial account requires $2500. At Vanguard, the minimum for opening either a 529 Plan or a custodial account is $3000 (Nevada residents can open 529 Plans for $1000.)

How a Custodial Account Can Teach about Investing

If you are interested in exploring saving for your child, you probably have already set up at least one custodial account: a savings account in their name at your bank. Unless the interest exceeded the limit ($1000 last year, $1050 for 2015), you haven’t been liable for taxes on it. Maybe you’ve been able to get your child actively involved in saving, so he can watch his money grow.

The problem is that today’s low interest rates on savings accounts aren’t going to get your kid very excited about the power of compounding.  Take our credit union: the published percentage rate on the kid’s savings accounts is 0.75%.  Savings accounts just aren’t going to generate meaningful income to get a kid excited about interest.

On the other hand, setting up a custodial brokerage account can allow for a lot more discussions about investing. Little ones aren’t going to engage in a lot of discussion about stocks and bonds, but custodial accounts can be a good way of introducing teenagers to the power of saving and investing. You’ll also be teaching them about taxes and other financial literacy topics.

Remember, you control the account, at least until the child reaches her majority.

If you make the investment choices, you can explain why you make the choices you do. You can apply your tried and true investment strategy, or do things to minimize income taxes like buying municipal bonds, growth-oriented stocks and mutual funds that don’t pay dividends, or US Savings Bonds that are not going to mature soon.

Even if you start with making the investments yourself, it might be a good idea after a while to let your child make some choices. You don’t have to relinquish control of the entire account. You might give the child a choice between 2 or 3 mutual funds or stocks, or you might earmark some of the money for his choices. If your child makes the choices with your guidance, you can teach him how to evaluate investments. He will have the chance to see the results of those choices, and he’ll benefit or pay for those choices just like he will later in life.

To make a custodial account a successful teaching tool, have regular financial reviews with your child. Make sure your child understands her investments before she makes them. Track results and discuss plans for how she will eventually use the money.

Is a Custodial Account Worth the Hassle?

Is a custodial account worth the extra risks, responsibilities and tax obligations? That’s going to depend on your personal situation.

If you are behind on your own savings and retirement planning, forget about it. Contributing to a custodial account is a luxury you can’t afford. You often hear “You can borrow money for college, but not for retirement.” Just because it’s a cliche doesn’t mean it’s false.

If you have family members contributing money explicitly for your child, it’s probably best to take advantage of a 529 plan and not worry about extra tax exposure on their income. If you  have family members contributing stocks or bonds explicitly for your child, you will have to take a look at the options. Is it better to sell the investments and put the money in a 529 plan, or hold the investments and transfer it into a custodial account? It will depend on the investments.

If your retirement savings is on track and you have savings, you should be saving for your child’s college education. That means a 529 plan first, especially while your child is too young to understand investments.  Take advantage of the tax breaks to build up the funds you’ll need to fund their education.

If you have the rest of your financial plan in place, and you can afford it, a custodial account can be a really great teaching tool. If your child has a real interest in investments, or if you are trying to get your child to develop an interest in investments, then consider having a custodial account in addition to a well-funded 529 plan. It may make your child more financially savvy and enthusiastic about saving money. If you can teach them to save and invest wisely, you’ve set them up for life. That’s worth a little hassle.

Under what circumstances would you consider opening a custodial account? What other ways could you use to teach older kids about investments?

This article is for informational purposes only. Everyone’s financial situation is different, and it may be best to consult with a professional advisor or planner before setting up any investment account.. 

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