A guide for parents: What is a custodial account?

As parents, we all want what’s best for our little ones. And when it comes to finances, one of the most powerful things we can do is to invest for our children’s future.

Did you know that if you invest just $100 per month for your child, from birth to age 18, they could wind up with over $57,000 (assuming 10% average returns)? Not bad at all!

But investing for a child works a bit differently than investing for yourself. The main way that parents can start investing for a child is to use a custodial account. But what is a custodial account, exactly?

What is a custodial account?

A custodial account is a type of savings account or investing account that an adult controls for a minor.

The adult serves as the “custodian” by taking care of the account until the minor becomes a legal adult. The minor is the “beneficiary” — the technical owner of the account.

While the beneficiary is a minor, all transactions and investing decisions must be approved and executed by the custodian. Once the minor becomes a legal adult (at age 18, in most cases), they gain control of the account and can make decisions and withdrawals.

Custodial accounts allow minors to benefit from accounts that they couldn’t normally open on their own. For instance, to start investing in stocks with a brokerage account, you must be 18 years old. Fortunately, a custodial account allows minors to bypass this age requirement, with the help of a legal adult.

Types of custodial accounts

Various banks, stock brokers, and financial institutions offer custodial accounts. Most accounts are based on the rules from one of two similar laws: The Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA).

UGMA and UTMA accounts are quite similar. Both allow an adult to set up an account on behalf of a minor and start investing in various assets. The main difference is the types of assets that can be purchased within each of these accounts:

• UGMA accounts: A UGMA account allows investing in stocks, bonds, mutual funds, exchange-traded funds (ETFs), cash, annuities, and insurance policies. They are somewhat more restrictive than UTMA accounts. UGMA accounts are available in all states.

• UTMA accounts: A UTMA account allows investing in stocks, bonds, mutual funds, ETFs, cash, annuities, insurance policies, intellectual property, real estate, and even artwork. UTMA accounts can hold almost any type of asset and accounts are available in all states except for South Carolina and Vermont.

As mentioned, these are the two main custodial account types. However, the term “custodial account” may also sometimes refer to other types of accounts, like custodial Roth IRAs (a form of retirement account) and 529 plans (a college savings plan).

How do custodial accounts work?

Here’s everything you need to know about how custodial accounts work, broken down into the most important topics.

Ownership and parties involved

Custodial accounts have two parties involved:

• The custodian, who must be a legal adult: The custodian is responsible for setting up the account, making investment decisions, and managing contributions. The custodian can be any legal adult, but parents and grandparents commonly serve as custodians for their younger family members.

• The beneficiary, who is typically a minor: The beneficiary is the technical owner of the account but cannot make any investment decisions or deposits/withdrawals.

The custodian remains in control of the account until the beneficiary becomes the “age of majority.” This is typically at age 18, although it can be as old as 21 in some states.

Once the beneficiary reaches the required age, they become the primary account owner and can use the money as they see fit. They can then make investment decisions, withdraw funds, or close the account down.

The transfer typically takes place automatically when the beneficiary reaches the age of majority. However, a few states allow transfers to be delayed if the account is titled to do so intentionally. For instance, California allows accounts to be set up to transfer as late as age 25. This kind of setup is uncommon. 

Contributions

A contribution is simply a deposit into a custodial account. Most custodial accounts have the following rules regarding contributions:

• Anyone can make a contribution, but they are typically managed by the custodian.

• Contributions are considered irrevocable gifts to the minor. This means that someone can’t later take out the contribution they made unless the money is then used to directly benefit the beneficiary.

• There are no contribution limits or restrictions. However, contributions may be subject to gift tax (see tax section below).

Distributions

Distributions are when money is taken out of a custodial account. Most custodial accounts have the following rules regarding withdrawals:

• Withdrawals must be managed by the custodian while the beneficiary remains a minor.

• Once the minor reaches legal adulthood, they can manage their own withdrawals

• Withdrawals must benefit the beneficiary. A custodian cannot withdraw money from a custodial account unless it’s specifically being used to benefit the beneficiary.

• Once the beneficiary takes control, they can use withdrawals for any purpose.

Taxes

Taxes may apply when large contributions are made and when money is withdrawn. Here are the general tax rules and benefits to consider:

• Custodial accounts have fewer tax advantages compared to accounts like a 529, Coverdell ESA, or Roth IRA.

• Contributions do not earn any tax benefits for the beneficiary or the contributor.

• Contributions may be subject to gift tax. In 2022, gifts of more than $16,000 per person per year must be reported to the IRS and may be subject to gift tax. For married couples, the $16,000 limit doubles to $32,000 per year.

• If your child’s unearned income, like dividends and capital gains, exceed the IRS’ threshold, you will need to file a tax return on behalf of your child or claim the income on your return. The threshold for 2022 is $2,300.

These are just the basics when it comes to tax rules. Speak to a financial advisor or CPA for details on custodial account taxes based on your personal situation.

Financial aid eligibility

Owning a custodial account could affect a child’s future eligibility for financial aid. Financial aid is often used to pay for college, and eligibility for aid is based on a student’s income, financial assets, and their family’s financial situation.

What is a custodial account’s impact on financial aid eligibility? Well, money kept in a custodial account is considered the child’s money — so it can directly affect financial aid eligibility by potentially reducing the amount of aid available. This isn’t a reason to avoid using custodial accounts, but it’s something to keep in mind when you’re planning out how to save for college.

Where can you open a custodial account?

Custodial accounts are offered by brokerage firms and registered broker-dealers like Fidelity, Vanguard, Schwab, and others.

Each company has slightly different rules and details, so it’s wise to consider multiple options.

Also, keep in mind that the rules and availability of account types may differ depending on where you live. For instance, Vermont and South Carolina don’t allow UTMA accounts, so residents of those states will only be able to use UGMA accounts.

Greenlight: The versatile alternative to a custodial account

Most parents and loved ones look into opening a custodial account for one simple reason: They want to start investing for their kids' future.

That’s an excellent goal! And a custodial account does enable investing — but it’s not the only option to consider.

Enter Greenlight, the all-in-one money app for kids. Greenlight is a powerful app that offers a debit card for kids and teens, financial education tools, an allowance and chores feature, and the ability to invest. It’s a way for kids and teens to learn a variety of important financial skills through hands-on experience.

Greenlight isn’t a traditional custodial account (it’s a standard brokerage account for parents), but the Investing for Parents feature allows you to invest in a variety of assets to benefit your kids. You can get started with as little as $1, and the app allows your children to monitor the progress of investments and learn as they go!

Custodial accounts enable investing for kids

A custodial account is simply a way for parents and loved ones to invest for a child’s future. An adult must serve as the custodian, while the child is the beneficiary. You can open a custodial account at a brokerage firm.

If you want even more bang for your buck, check out Greenlight. With the Greenlight app, parents can invest for their children — while also teaching them valuable financial literacy skills through hands-on experience.