Saving for your child’s future, and in turn teaching your child about investing, can be among the biggest long-term concerns for any parent.
One way to do both is with a custodial brokerage account, often referred to as an UTMA or UGMA account — named for the Uniform Transfer to Minors Act and the Uniform Gift to Minors Act — that is managed by a parent or other adult in the name of the minor.
While you can’t predict the future, you can start preparing for it. Whether you want to pay for a child’s expenses, give a financial gift or start building a nest egg, here is your guide to understand how a custodial brokerage account can serve your and your child’s financial future:
— What is a custodial brokerage account?
— Benefits of a custodial brokerage account.
— Drawbacks of a custodial brokerage account.
— Should you open a custodial brokerage account?
What Is a Custodial Brokerage Account?
Since minors do not have the right to purchase investment securities like stocks, bonds and index funds, an adult has to serve as the account’s custodian. Typically, a parent or grandparent would open a custodial account for a child to save for the future or give financial gifts.
Custodial accounts also allow for a transfer of assets to minors when they reach legal adulthood. There are two general types of custodial accounts: UTMAs and UGMAs. The main difference between the two is the type of assets that can be held in each account. The UGMA custodial account allows you to hold financial assets like stocks, bonds, index funds, certificates of deposit, cash and insurance policies, while the UTMA goes beyond traditional assets and allows you to hold asset classes like real estate or fine art.
In both cases, the child is the beneficiary of the custodial account, while the adult is the custodian, or the person who manages the account. The custodian’s responsibility is to manage the account’s assets until the minor reaches adulthood.
Opening a custodial account is similar to opening any brokerage account. You will need the child’s personal information, as well as your own. Initially, the account will be in your name. Once you’ve opened the account, then you can choose investments on behalf of the minor.
In fact, custodians make all the account’s investment decisions until the account is transferred when the child is old enough. Custodial accounts are what’s known as an irrevocable gift. This means custodians must transfer the account to the beneficiary, usually at the age of majority as required in your state, typically 18 or 21.
Depending on the state you live in, custodians can specify an older age when the child can take control of the account. When the child reaches the designated majority age, they become the account holder and have complete control of the account. There is an option to make the custodian a joint account holder, if desired.
Benefits of a Custodial Brokerage Account
A custodial account is easy to open, and with its simplicity , it can be a good alternative to a trust, which generally requires a lawyer, says Shari Greco Reiches, wealth manager and behavioral finance expert at Rappaport Reiches Capital Management, based in Evanston, Illinois. She points out that the beneficiary can use the funds for any reason.
Parents, grandparents, other family members or friends can gift money for a child in a custodial account. This is an easy way to grow the account.
A custodial account can also serve as an opportunity to teach children the value of investing and how to build wealth from a young age. This can be an opportunity for custodians to show minors financial investments that are held in the account and explain how investing works. This can be a great way to educate children on how to manage money for the long term starting from a young age.
Another benefit is that there is flexibility when it comes to managing activities in a custodial account. Contributions to the account can come from parents, family members and friends, and custodial accounts do not have contribution limits. While there is no minimum amount needed to open this type of account, the investments you choose may require a minimum.
Account withdrawals can be made even when the beneficiary is a minor, though these must be for the benefit of the minor, such as covering costs for education or medical bills.
Drawbacks of a Custodial Brokerage Account
One drawback to having a custodial account for a minor can rear its head when the child applies for financial aid for college.
“Custodial accounts can cause issues with financial aid for the college as it will be considered an asset of the minor,” says Brett Bernstein, CEO and co-founder at XML Financial Group in Rockville, Maryland. This can weigh against the student’s aid eligibility.
Further, there aren’t many tax advantages when it comes to holding a custodial account. If parents want to save for their child’s future education expenses, a 529 plan may be a better alternative.
“A 529 plan account grows tax-free, and withdrawals for qualified educational expenses are not taxed,” Reiches says.
UGMA and UTMA brokerage accounts have tax benefits, but they are minimal. For minors or young adults on their parents’ tax return, up to $1,100 of realized gains such as dividends may be exempt from federal income tax, with the next $1,100 taxed at the child’s rate. But any income over $2,200 is taxed at the parents’ rate.
Adults who wish to contribute to a custodial account also can give up to $15,000 in a year — $30,000 for a married couple filing jointly — without triggering the federal gift tax.
“The minimal tax benefits should not be the driving force for custodial accounts,” Bernstein says.
Also, while custodial accounts can act as a way to transfer wealth, they may not be advisable for significant amounts of it. This is because the money goes to the child as soon as they attain the age of majority, Bernstein says.
“You see more high-level estate planning with trusts being utilized for proper wealth transfer, as well as not giving a young adult legal access and control to a lot of money,” he says.
Another aspect of a custodial account that can be viewed as a challenge is that it’s irrevocable, which means these accounts cannot be reversed or changed. Once the minor comes of legal age, the assets in the account are in their possession.
This could be an issue if you don’t think the holder will be able to handle this financial obligation and responsibility. In that case, you may want to work with a financial professional to transfer the assets from the custodial account to another account.
Should You Open a Custodial Brokerage Account?
If you want to prepare your children or other young family members for a good financial foundation while building an investing mindset, a custodial account could be a key tool. It can be a great way to start the investing conversation, especially if your child expresses interest in investing in a particular security.
There may be other investment vehicles that could serve as better alternatives than a custodial account, depending on the family’s circumstances, such as 529 plans for building a college fund or estate planning to manage real assets or transfer a large amount of wealth.
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