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custodial account

Looking to invest in your child’s future or teach him or her about the power of compound interest? A great way to do so is through a custodial account. With a custodial account, you can transfer funds to a minor easily while keeping the money safe until the minor is of age. You can even get some tax benefits along the way.

Custodial accounts come in a few different shapes and sizes. And each kind has its own upsides and drawbacks. Read on to learn what a custodial account is, how it works and if it’s the right option for you and your child.

Custodial Accounts Defined

A custodial account is really any type of financial account that one person opens and maintains for another person. In most cases, it’s a brokerage account or savings account that an adult controls for a child under the age of 18. Once the child is of age, he or she assumes ownership and can control the account how he or she wishes.

One of the most common types of custodial accounts is a Coverdell Education Savings Account (ESA). Parents or guardians can use a Coverdell ESA to save up for a child’s education while enjoying some tax benefits. Two other custodial accounts are UTMA and UGMA accounts. These accounts typically have fewer restrictions than an ESA.

custodial account

How Do Custodial Accounts Work?

How a custodial account will work will depend on the type of account you open. As we’ve mentioned, not all custodial accounts are created equal. A Coverdell ESA is an alternative to other education savings plans like 529 college savings plans, and it has some helpful tax benefits. Any money that your investment earns within the account will be tax-deferred. Furthermore, any withdrawals you make for education expenses will be tax-free. Keep in mind, however, that you need to use the money on education expenses in order to get these tax benefits.

Coverdell ESAs also have a few limitations that can complicate things. First, these accounts are only available to individuals and families under a certain income level. Also, you can only contribute a maximum of $2,000 per year to your ESA. That said, you can get around this limit by setting up multiple ESAs for the same beneficiary if you wish.

Another category of custodial accounts are the Uniform Transfer to Minors Act (UTMA) account and the Uniform Gift to Minors Act (UGMA) account.

The UTMA  is essentially a way to transfer assets to a minor without having to create a trust or make things too complicated. There are no contribution limits for UTMA accounts, and you can open one no matter your income. Funds in a UTMA account are restricted to use for the minor’s benefit. Such a restriction, however, isn’t as narrow as those for an ESA. A plus of the UTMA account is you can use it to teach your child about the benefits of investing. Your child can watch the investments grow, then he or she can take control of the account with some knowledge about how the account works.

You can also open a UGMA account if you wish. This account gives you a lot of flexibility regarding what you’re giving the beneficiary. You can deposit money, savings bonds, stocks, annuities and even life insurance. The most important thing to consider with a UGMA account is that creating the account is irrevocable. Once you put the funds in the account, you can only spend it if it’s explicitly for the minor’s benefit.

How Can You Open a Custodial Account?

One benefit of custodial accounts are that they are very easy to open. You can head to most brokerage firms, either in person or online, to set up the account. Popular firms like Fidelity, Charles Schwab and Ally all offer custodial accounts. As with any brokerage account, you’ll want to examine what kinds of fees are associated with the account before making your decision.

When you open the account, you’ll need to provide information about both you and the beneficiary of the account. Things like your address, Social Security number and contact information will be necessary. And, of course, you’ll need the money you intend to invest.

custodial account

Should You Get a Custodial Account?

A custodial account is a great way to save up for your child’s future. That’s the case whether you’re stockpiling cash for higher education or otherwise. You’ll know that while your child grows, he or she will have some money maturing as well. The tax benefits that come with custodial accounts can be an extra bonus as well.

That said, you should make sure to think through all the options before deciding if a custodial account is right for you. One of the biggest factors in such a decision is examining the impact of these accounts on financial aid. Assets in a custodial account will count as a child’s assets when that child applies for financial aid. If you have a lot of money in the account, your child could miss out on thousands in potential aid.

Another factor to consider is the minor for whom you’re opening the account. With UTMA and UGMA accounts, the minor is in full control of the account and its assets once he or she is of age. You may be worried your child still might not spend the money in the most responsible fashion at 18 or 21. In that case, this might not be the account for you.

Tips for Banking Responsibly

  • When it comes to investing, it’s extremely important to have a diversified portfolio so you’re protected from risk. If you’re using a custodial account to introduce your child to investing, make sure to stress the importance of diversifying.
  • You might also do better really boosting your savings elsewhere, especially with an online bank. Online banks don’t have to worry about maintaining physical branches. That allows these banks to pass those savings onto their customers in the form of high-yield savings accounts and CD rates.
  • If you already have some money to spare, you could save even more by finding a financial advisor. A financial advisor can take a comprehensive look at your finances and determine where you can cut expenses and save more. To find the right advisor, you can use SmartAsset’s free advisor matching tool. You can answer a series of questions about your financial goals and situation. Then the tool will match you with three qualified financial advisors in your area.

Photo credit: ©iStock.com/andresr, ©iStock.com/Rawpixel, ©iStock.com/Sasiistock

Hunter Kuffel, CEPF® Hunter Kuffel is a personal finance writer with expertise in savings, retirement and investing. Hunter is a Certified Educator in Personal Finance® (CEPF®) and a member of the Society for Advancing Business Editing and Writing. He graduated from the University of Notre Dame and currently lives in New York City.
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