There’s an old proverb that says if you give a man a fish, you can feed him for a day. But if you teach him to catch his own fish, you can feed him for life. The same can be said for teaching your child to invest.
You can save for your child’s future and help her through college and possibly beyond, but eventually your savings will likely run out and she’ll need to fend for herself. If you teach her to save and invest early, however, she’ll be set up to maximize both your savings and her own for life.
[Sign up for stock news with our Invested newsletter.]
This is the power of a custodial brokerage account: You can simultaneously save up fish for your child’s future, and teach her how to capture more fish down the road.
Here is your guide to understanding how a custodial brokerage account can serve 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?
A custodial brokerage account is an investment account that is managed by an adult on behalf of a child. When the child reaches the age of majority in her state, she gets full control of the account.
Typically, custodial brokerage accounts are opened by parents or grandparents who want to save for the child’s future or make financial gifts to the child. Anyone can contribute to the account, not just the account owner, and there is no limit on how much you can contribute in a given year. However, any contributions over the annual gift tax limit will be subject to federal gift tax. In 2023, that limit is $17,000 per person.
Contributions to a custodial brokerage account are considered irrevocable gifts, meaning once they go in, they can only be used for the minor’s benefit. That benefit isn’t limited to educational costs, like with college savings plans. The funds can be used at any time and for any purpose as long as it’s for the minor.
There are two types of custodial brokerage accounts: UGMAs and UTMAs. The main difference between the two is the type of assets that can be held in each account. Uniform Gifts to Minors Act accounts, or UGMAs, allow minors to hold financial assets like stocks, bonds, index funds, certificates of deposit, cash and insurance policies, while Uniform Transfer to Minors Act accounts, or UTMAs, go beyond traditional assets and allow minors 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. Adulthood is defined as the age of majority, which is typically 18 or 21 but varies by state. Some states allow the custodian to specify an older age when account ownership will transfer.
“Custodial accounts are also subject to the laws of the state in which they are established,” says Derek Miser, investment advisor and CEO of Miser Wealth Partners in Knoxville, Tennessee. “Therefore, it is important to understand each state’s specific rules and regulations before investing in a custodial brokerage account.”
Benefits of a Custodial Brokerage Account
Custodial brokerage accounts are easy to open at a bank or financial institution. You will need your child’s personal information, including their Social Security number, as well as your own. Once opened, you can fund it and choose investments as you would in any other brokerage account.
“The main benefit of a custodial brokerage account is that it allows minors to begin investing in the stock market at an early age,” Miser says. The earlier you start investing for your child’s future, the bigger their future nest egg can become.
“Custodial accounts can also be beneficial for parents to teach their children about investing and money management,” he says. This is where you can teach her to fish while also helping her stock away fish for her future.
[READ: 7 Investment Apps for Beginners]
Another benefit 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 custodial brokerage accounts is that UGMA and UTMA accounts are considered assets of the minor when applying for college financial aid. One way around this is to liquidate the UGMA or UTMA and transfer the assets to a 529 college savings plan. These accounts are treated as an asset of the parent on the Free Application for Federal Student Aid, or FAFSA, which would have less of an impact on financial aid eligibility.
UGMAs and UTMAs also have fewer tax benefits than 529 accounts. For minors or young adults on their parents’ tax return, up to $1,250 of realized gains such as dividends may be exempt from federal income tax, with the next $1,250 taxed at the child’s rate. But any income over this amount is taxed at the parents’ rate.
Adults who wish to contribute to a custodial account also can give up to $17,000 in 2023 — $34,000 for a married couple filing jointly — without triggering the federal gift tax.
By comparison, 529 plan assets grow tax-free, and all withdrawals for qualified educational expenses are not taxed.
Finally, some parents may be concerned about the automatic transfer of ownership that occurs with custodial brokerage accounts. As soon as your child reaches the age of majority, she can take control of the account. While some 18 or 21 year olds may be mature enough to handle this much financial responsibility, others might not be, so it’s something to keep in mind.
Should You Open a Custodial Brokerage Account?
Custodial brokerage accounts can be great tools to prepare children for a good financial future by both fishing for them and teaching them to fish for themselves down the road. These accounts are natural segues to investing conversations and provide a lot of flexibility in how the assets are used.
If you only plan to use the savings for education expenses, however, there may be better alternatives, such as 529 plans. Before opening a custodial brokerage account, be sure to research the various savings options available to you to determine which is the best option for your situation and goals.
More from U.S. News
5 Best Tech ETFs to Buy for 2023
10 of the Best-Performing 401(k) Funds
5 Apps for Socially Responsible Investing
Guide to Custodial Brokerage Accounts originally appeared on usnews.com
Update 03/30/23: This story was published at an earlier date and has been updated with new information.
