Most parents want the same thing–to get their children off to a healthy financial start in life. It’s a great feeling to know that your kids are heading out into the world with some money (and financial knowledge) in their pockets.
If you’re interested in planning more for your child’s financial future, you may want to consider a custodial account. It’s a type of savings account for your children, with a number of investing and tax benefits, and you can contribute to it until your child reaches adulthood.
There are key differences between a custodial account and a 529 account, another popular savings option.
Here’s the most important one: With a custodial account, the money is essentially a gift to the child, and once they reach adulthood, it’s theirs to use however they want. They can, for example, use it to fund their education, start a business, purchase a first home, or buy a car.
By contrast, a 529 must be used exclusively to fund higher education, including tuition, room and board, books and supplies, and computers.
Let’s get down to the nitty gritty:
What’s a custodial account?
Custodial accounts have been around for decades. They are also known as Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) accounts. Generally speaking, different states typically allow one versus another. UTMAs allow for investments in more types of assets, including real estate. UGMAs confine themselves to more traditional securities.
Who can open a custodial account?
Any adult–parent, grandparent, aunt or uncle, for example–can open up a custodial account for a minor. Generally speaking, only the custodian makes contributions to the custodial account.
How do you open a custodial account?
Most banks and online brokers offer custodial accounts as part of their package of investment offerings. Stash also offers custodial accounts.
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How much can you contribute to a custodian account?
There’s no limit to how much a custodian can put into an account each year, and no maximum lifetime limit.
Important tax note: The custodian can put up to $15,000 into the account, without triggering the gift tax. (For married couples, the amount is $30,000 for 2018.) Annual contributions, however, are not tax-deferred as they are with retirement accounts such as a traditional IRAs. Please consult a tax professional to further discuss the most ideal approach for your personal tax situation.
What happens next?
Once the account is funded, you can invest the funds just like you would in any other investment account. That means the cash can be invested in stocks, bonds, mutual funds and ETFs. So a custodial account can be, potentially, a teaching tool to show your children how to invest, and how money can grow over time.
Here’s something really important to keep in mind: Any securities or funds transferred into a custodial account immediately and irrevocably become the property of the minor. However, The custodian has the sole responsibility of managing the assets until the beneficiary becomes an adult, and the custodial relationship concludes.
Withdrawing from the account
Once placed in the account the money belongs to the minor. Nevertheless, the custodian can take cash out of the account at any time, as long as the funds are used to benefit the minor, according to investing and tax services company Fairmark.com. However, there may be charges including liquidation fees or any back end fees for mutual funds or other securities. The capital gains might also need to be reported on the child’s tax return, or the parent’s.
Once the minor becomes an adult–which ranges from 18 to 21 based on individual state laws–he or she can use the money for anything.
What about taxes?
The first $1,050 of income, or capital gains, from the account is not taxed annually. After that, it’s taxed at the child’s rate, generally between 10% and 15%, for 2016. Any amount over $2,100 is then taxed at the custodian’s higher individual income tax rate, according to the IRS. As mentioned previously, it’s best to consult a professional tax advisor to walk you through this process.
A custodial account counts as an asset for the beneficiary, and can affect the ability of your child to get financial aid, potentially reducing the amount of assistance they receive.
- A 529 must be used exclusively to fund a child’s higher education, or for related educational expenses.
- The minor is not the owner. Instead, the custodian of the account maintains control for as long as the account exists.
- There are lifetime contribution limits to a 529, which vary by state and are generally between $235,000 and $512,000, according to US News & World Report.
- Money in a 529 is typically invested in a portfolio of stocks, bonds and funds.
- Unlike a custodial account, earnings in a 529 grow on a tax-deferred basis.
- 529s are offered by individual states, but you are not limited to your state of residence to select a plan.
- Most states offer a tax deduction for funding the accounts, and you don’t pay federal or state taxes for distributions that go toward qualified educational expenses.
- Like a custodial account, a 529 is considered an asset that can reduce financial aid.