How a Custodial Account Works
A custodial account functions just like any other financial account, with extra features to help a parent keep an eye on the account.
Both the sponsor and the child can contribute to the account. The sponsor must technically decide how to invest the funds, but this is more flexible than it sounds! A sponsor can decide to “auto approve” stock orders on apps like Bloom, or opt to approve or deny every stock order.
Custodial accounts can own a variety of assets! From stocks, crypto, real estate and even famous paintings! Most custodial investing apps focus on stocks and crypto.
Authority of the account formally shifts from the custodian to the designated beneficiary after the juvenile reaches the legal adult age in their state; at that moment, they assert full control and usage of the funds. The account will become a part of the child's estate if the minor passes away before reaching the age of majority.
Types of Custodial Accounts
There are two main types of custodial accounts: UTMA and UGMA. Both have the same tax-advantages and the same custodial/sponsor restrictions.
Otherwise, neither accounts have a contribution limit or spending restrictions - you can use the profits however you’d like!
- Newer, based off an UGMA
- Can hold many financial assets! Stocks, real estate, intellectual property (trademarks and copyrights), works of arts, bonds, etc
- Allowed in all states except South Carolina (as of 2022)
- Original / older
- Cash assets only
- Allowed in all 50 states
- Same gifting advantages (up to $16k/year in 2022 tax-free and up to $17k/year in 2023 tax-free)
- No contribution limit
- Not spending restrictions
- Sponsor/custodian required
Advantages and Disadvantages of Custodial Accounts
There are advantages, including tax advantages, for custodial accounts. But there are also downsides, including the risk that the account will limit the amount the child can access in financial aid in college.
Advantages of Custodial Accounts
- Incredibly flexible (no income or contribution limits, and no requirements to make regular distributions at any point)
- No withdrawal penalties. While all withdrawn funds must be used "for the benefit of the minor," unlike college savings plans, this restriction is ambiguous and does not only apply to educational expenses.
- Easier and more simple to setup than a trust fund
- Custodial accounts do offer some tax benefits, despite not being tax-deferred like IRAs. Up to a certain amount, the earnings in the account are taxed at the kid's tax rate since the IRS views the minor child as the account's owner.
- A specific amount of "unearned income" is permitted for each child who files as part of their parents' tax return and is under the age of 19 (or 24, if the child is a full-time student).
- Unearned income is not taxed for the first $1,150 in 2022; the subsequent $1,150 is subject to 10% tax. More over $2,300 in income will be taxed at the parent's rate. The juvenile may, however, submit a tax return on their own once they have reached the state's legal majority age.
- The beneficiary's tax bracket at the time of filing will apply to all account earnings at this age.
- Also, for the 2022 tax year, an individual is exempt from the federal gift tax if they make a contribution to an account of up to $16,000.
- For the tax year 2023, this exclusion from gift taxes will rise to $17,000 per person.
Disadvantages of Custodial Accounts
- Ownership of significant assets may reduce a child's financial aid eligibility for college or another government program
- All of the account's holdings pass, irrevocably, to the minor at the age of majority.
- The teen under the custodial account cannot be switched! So, if you have two kids, you’d need separate accounts for each and you couldn’t pull a switch-a-roo!
Pro Con Summary of Custodial Accounts
- Easy to establish and manage
- Free from income, contribution, or withdrawal limits
- Can invest in a variety of assets
- Less tax-advantaged than other accounts
- Can hurt child's financial aid prospects
- Irrevocably pass to child upon majority
Examples of a Custodial Account
The majority of brokerages, both online and offline, provide custodial accounts. Terms of custodial accounts typically correspond to those of regular, non-tax-favored accounts for individuals.
If you do not want to go through the hassle of setting up a custodial account through a big, slow bank, you can checkout apps like Bloom! Bloom also helps teens master personal finance and investing, so they can invest intelligently.
Can You Withdraw Money From a Custodial Account?
Yes! Money can be withdrawn from custodial accounts at any time. The only restriction is that funds must be "for the benefit of the minor”! This is incredibly vague, but is often used for:
- Toys / Games
- Educational Expenses
- Rent / Housing
- Devices / Expensive Gifts
Any of the above! As long as the use of funds somehow benefits the minor (ex, moving into a new home for the whole family).
What Do You Do With a Custodial Account When Your Child Turns 18?
All funds and the account are transferred to the minor as soon as they reach the age of majority! Always sad to see them grow up, but at least your teen will have 100% ownership of their account.
How Is a Custodial Account Taxed?
Frequently, children file alongside their parents' tax return. Up to $1,150 of account earnings will be tax deductible in 2022, with the subsequent $1,150 subject to 10% tax instead.
Any further earnings are then taxed in accordance with IRS regulations at the child's parent's tax rate.
How Do I Get a Custodial Account?
If you are under the age of either 18 or 25, depending on the state, a parent can help you sign up for a custodial account with apps like Bloom. Bloom is an investing and financial literacy app for teens under the age of 18!
An adult can start a savings or investing account for a child through a custodial account. A custodial account has certain tax benefits, but there are also risks, such as the chance that the account's existence will reduce the amount of financial aid a child may be eligible for.