5 things to know about custodial accounts for kids

Can You Withdraw Money from a Kids Savings Account?

In almost all situations, a traditional bank, credit union, or investment company will not open a kid’s savings account without the presence and signature of a parent or legal guardian. That’s because minors cannot legally consent and sign the bank’s agreements. 

Therefore, as a parent or guardian, you become a joint-owner or custodian of the kids’ savings account. These are typically referred to as custodial accounts.

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Opening a Childrens Regular Savings Account Under Your Childs Name

Opening a savings or investment account in your child’s name has specific pros and cons.

Advantages

  • Compounded interest: The earlier your child starts saving or investing, the better. Time is their most significant asset, and an early start will generate a lot of passive income over their childhood.
  • Fewer fees and restrictions: The best savings account for kids typically have no minimum balance requirements, no income verification requirements, low to no-fee policies, and other budgetary advantages not commonly seen in adult savings accounts.
  • Tax implications: Depending on your state and your tax bracket, custodial accounts can be a strategic way to give your children money while avoiding estate and gift taxes. 

Disadvantages

  • Taxes for your child: Minors typically file their taxes as part of their parent’s annual tax return. Depending on how much they earned in their savings or investment accounts, some of the interest or return that their savings generated may be taxed.
  • Taxes for you: Estate and gift taxes are complex, and some parents may unwittingly surpass their state’s tax laws and trigger significant taxes if they deposit too much money into a custodial account.
  • Strategy: Unless you’re working with a financial institution that’s primarily focused on helping your child save for their future, the services and products at many traditional banks may not be beneficial for your child’s own financial goals.
  • Long-term responsibility: Remember that the custodial account will convert fully to the child’s ownership on their 18th or 21st birthday. Because a broad savings or investment account doesn’t have use-specific regulations the same way something like a 529 Plan account does (which is specifically limited to college and school expenses), you’ll need to trust in your child’s financial instincts and responsibilities.

The Reason Your Childs UTMA Assets Are Protected

Legally speaking, two things occurred the moment assets were gifted under the UTMA law, whether or not the donor was fully aware of UTMA restrictions on withdrawals.

It became an immediately vested, irrevocable gift

Typically, neither you nor any other donor can withdraw money deposited into a UTMA back for any reason (this includes cases in which the child dies; the UTMA funds are part of their probate estate and need to be settled accordingly). The funds must be handed over to the child at the age of maturity, which is determined at the time of the gifting, and it can be as high as age 25. If no age is predetermined, then it defaults to either 18 or 21, depending on state law.

There's no scenario under which you can take that money back. It doesn't matter if you think the funds are too much for them to handle. They can tell you they plan on dropping out of college and gambling away the rest of their savings in Las Vegas—that's their choice, and it's their money. Anything you do to try to stop them from spending the money how they want is going to put you in a legally precarious position.

As the account custodian, you owe a fiduciary duty to your child

In the United States, a child's money does not belong to the child's parents or guardians. Once the paperwork is in order, as a custodian of a UTMA you become a fiduciary or you owe a fiduciary duty to the beneficiary of that account.

Fiduciary duty” means you can only use the money in their best interest. You must invest it in a manner consistent with the “prudent person rule.” You also can’t use the funds for necessary expenses such as food or shelter, because you are legally obligated to provide those as a parent.

"Once you've put someone in that fiduciary capacity, no they can't be paying if the child support obligations is theirs individually," Jason Haselkorn, an investment fraud attorney and Partner at Haselkorn & Thibaut told The Balance in an interview. "They can't be taking money that belongs to the beneficiary to pay a child support obligation because as a trustee and as a fiduciary you are basically pilfering the beneficiary's money even if the money is going towards the benefit of that beneficiary," he added.

This fiduciary obligation is also what makes it so hard to understand what is permissible and what is not because the law varies by state. "Now you're under that state's common law and each state has its own common law case law and principles that'll develop," said Haselkon.

As part of the fiduciary obligation, you are also required to keep detailed accounting records, down to the penny, of every cash flow into or out of the account. If the child requests accounting records, even decades after it was first established (as is often the case when babies or young children are gifted stock), you'll be compelled by the courts to produce it (if you don't do so voluntarily).

You would think these rules would be fairly straightforward. Yet, parents continue to wrongly state, often with conviction, that they are perfectly within their rights to spend a child’s money, undo a previous transfer, or somehow stop an irresponsible child from accessing UTMA principal. By cashing checks on behalf of a child, the parent agrees, knowingly or unknowingly, to take on the obligations and liabilities of custodianship. The donor or the child could easily come back and sue the parent if the parent mismanages those funds. Even without malicious intent, it’s illegal to do anything with the money that the child doesn’t ask for. A child could technically sue for something as simple as moving the UTMA money into a regular 529 college savings plan.

Legal proceedings could result in the restitution of the funds you took, payment of foregone investment income that should have been generated, attorney fees, and a host of other expenses that can (and probably will) be more costly than the money you used. 

What are my investment options for a custodial account?

Custodial brokerage accounts function much like regular brokerage accounts. This means you have access to the same array of investment options, from exchange-traded funds (ETFs) and mutual funds to individual stocks. You can also opt for predesigned diversified mixes, like those you’d find in an Acorns portfolio.

What are the advantages of a custodial account?

One benefit of custodial brokerage accounts is that they allow you to continue to invest money on behalf of a child without you having to hold legal ownership of those assets. That is particularly valuable for income tax purposes, because unearned income in a custodial account typically gets taxed to the child rather than to the person managing the account. Because most children have little or no earned income, they're often in lower tax brackets than their parents or other relatives, and so having investment income taxed on their returns can lead to lower tax bills or even no tax liability at all.

In addition, custodial accounts give you maximum flexibility in using the money on the child's behalf. That stands in contrast to some other types of savings vehicles for children, such as 529 educational savings plans, which require you to spend account money on qualifying educational expenses or else pay a penalty to the IRS.

Are Custodial Accounts a Good Idea?

A custodial brokerage account can serve as an exce

A custodial brokerage account can serve as an excellent way to make a financial gift to a child. This can be for your own child but also a child of a relative or friend.

This type of account can go toward a child’s future benefit but you’ll also want to consider the legal and tax implications of opening one first.

From a tax perspective, these accounts provide some tax advantages by shielding a certain amount of unearned income from taxation each year while allowing another portion to remain subject to taxes only at the child’s tax rate.

Above this, the parent’s tax rate absorbs any income in excess of these limits.

While good in some respects, especially compared to a traditional taxable brokerage account, if the real goal for these funds is long-term appreciation for a safe and secure retirement, opening a custodial IRA might be more fitting.

This requires the minor to have earned income, but it also carries these tax advantages through retirement and not just an annual income level in the account. Plus, you’ll need to pay capital gains taxes on the assets held in the custodial account when you sell at some point in the future.

As a final point, these accounts may mean you’ll need to file annual tax returns for your child. While not a problem for some, this can be an added hurdle you don’t wish to cross.

As for the legal ramifications, the assets held in the account legally belong to the minor. This means they will count on the FAFSA as available financial resources and could potentially reduce available needs-based financial aid.

All of this said, these accounts still provide a powerful way to start investing as a minor and will certainly outperform funds held in a savings account or other banking apps for minors while also building potential investment income down the road.

Compared to doing nothing or investing in a standard brokerage account, these accounts can provide plenty of upside worth considering as well.

Paired with a bank account and useful investing books for kids, this account can serve as a solid financial foundation for teaching kids about financial literacy with skin in the game.

Who Pays Taxes on an UTMA Account?

Taxes are one area in which the UGMA and UTMA are pretty similar. Because the assets held in custodial accounts are the legal property of child beneficiaries, the IRS taxes the earnings generated by an UTMA or UGMA at the child’s tax rate — but only up to a certain point.

(Image source)
(Image source)

In 2021, the first $1,100 of unearned income is tax-free. “Unearned income” is essentially any profit you make from cumulative interest. 

The next $1,100 in profit an account generates is taxed at a rate of 10%. 

Any amount of income an account produces that’s more than $2,200 will be taxed at the parent’s higher rate.

Once the child beneficiary reaches the age of majority in your state, they’ll be able to file a tax return of their own. That means the account earnings in their custodial account will then be subject to the tax bracket relevant to their age.

But as always, there’s an exception to the rule when it comes to filing tax returns.

If you’re under 19 or a full-time student under 24 years old, you can keep filing your taxes as part of your parents’ tax return.

It’s also important to consider the IRS gift tax exclusion. 

If you gift someone loads and loads of money, the IRS will tax that gift unless its total sum is under a certain threshold. This threshold is called the “gift tax exclusion.” In 2021, the exclusion was set at $15,000 per year.

In short, how UTMAs are taxed can provide families with significant savings — but only up to a certain point. That’s why it’s important to plan and consider tax obligations beforehand.

Custodial account options

Finding the right brokerage to open your custodial account isn’t too difficult, as you have plenty of choices by searching for online brokerage accounts. You’ll want to choose one that offers custodial accounts and doesn’t have any account fees or minimum investment requirements.

As your child grows, it’s a good idea to begin teaching them about money management and investing. Allowing them to choose some of their investments and watch how they do is a great learning opportunity for them.

How to use a custodial account

When it comes to preparing a child for the future, giving them a head start financially can be beneficial. Whether you want to help them with college savings, financing a special occasion, or building a nest egg for their future, custodial accounts can help you get there.

It’s easy to open a custodial account as it’s just like opening any savings account or brokerage account. Along with the minor’s personal information and social security number, you’ll also need to provide your own as the custodian of the account.

After it’s set up, a custodial account works just like any other bank or investment account. The custodian manages the account and can make deposits and invest as they see fit as long as it benefits the minor.

The account custodian can choose any type of investments allowed by the specific account, as listed above. However, before the child becomes of legal age, the custodian will make all investment decisions for the account with the minor beneficiary’s best interests in mind.

When the minor becomes of age in their state of residence, usually 18 to 21 years old, the account transfers to them. They assume control over that account, including any taxes associated with the account.

For example:

Dave and Sue have a child named Joe. They plan to save for medical school and open a custodial account to do so. They choose a Uniform Transfers to Minors Act (UTMA) account which allows Dave and Sue to make gift donations in the form of intellectual property, artwork, cash, real estate, and investments such as stocks, bonds, and mutual funds.

Since there aren’t limits on how much they can contribute to the account and understand the expense of medical school, they spend the next 18 years putting assets into the account.

Joe is a good kid but isn’t a great student. He hates the idea of medical school and wants to skip college altogether to work on his artistic talents as a writer, painter, and musician.

His parents aren’t happy about his plans. Still, when Joe turns 18, which is the legal age in his state of residence, he gains control of his UTMA account and begins using the money to pursue his own goals.

Although Dave and Sue are disappointed, there’s nothing they can do as the account is irrevocable. All control over the assets in that account now belongs entirely to Joe, who gets to decide how he uses the money.

Custodian accounts vs. trust funds

When it comes to planning for a beneficiary’s financial future, the most important goal usually comes down to finding the method that allows the beneficiary to receive the gift you intended in a way that makes the most sense.

There are 2 main options to consider when choosing how to leave assets to a minor and include a Uniform Transfers to Minors Act (UTMA) account and trust funds. They each have both benefits and drawbacks to consider before making a final choice.

Trust fund basics

A trust is a legal document that grants a beneficiary assets as spelled out in the document and owned by a trust. It may have detailed rules associated with managing it and may include a specific set of terms.

Some of those terms can include parameters such as the beneficiary must graduate from college or only receive a specific amount of money in payouts instead of being awarded the entire trust.

Trust advantages

  • A trust allows you to dictate the terms of the trust as well as how and when assets can be distributed.
  • Trusts protect assets from financial hardships and bankruptcy if the account’s trustee has financial troubles.
  • Trusts protect privacy and can eliminate the need for probate in the event of a death.

Trust disadvantages

  • Trusts are costly and time-consuming to set up.
  • Trusts limit flexibility and must abide by the terms set.

UTMA basics

As discussed earlier, UTMA accounts are types of custodial accounts in the name of the beneficiary where financial gifts and property can be given to a minor. Under the rules in which a UTMA account works, the minor beneficiary is the owner of the account but has a custodian that manages that account.

The account management stays with the custodian until the minor becomes of legal age in their state of residence. Then, the account is transferred to them, and they assume all responsibilities of managing the account.

Custodial Accounts for Grandchildren

A custodian can open a custodial account for grandchildren. This is different from some other account types like IRAs because it doesn’t require the child to have earned income in order to contribute to the account.

The custodian may be an individual or organization, such as a bank or brokerage firm. Grandparents can set up custodian accounts to invest in assets to benefit the grandchild.

This often acts as the best investments for grandchildren and best investments for kids. Have a look at the investing apps above to get a sense of where you can open custodial accounts.

About the Site Author and Blog

In 2018, I was winding down a stint in investor relations and found myself newly equipped with a CPA, added insight on how investors behave in markets, and a load of free time.  My job routinely required extended work hours, complex assignments, and tight deadlines.  Seeking to maintain my momentum, I wanted to chase something ambitious.

I chose to start this financial independence blog as my next step, recognizing both the challenge and opportunity.  I launched the site with encouragement from my wife as a means to lay out our financial independence journey and connect with and help others who share the same goal.

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