A custodial account is an account that’s in someone’s name but controlled by another person, called the custodian.
In many cases, the custodian is a parent of a minor child.
Each state has different laws about opening and using a custodial account, so it’s important to check with your state or consult an attorney if you’re considering this type of account.
How Does a Custodial Account Work?
A custodial account can be set up in a variety of ways, but oftentimes it’s simply an account that parents set up for their children.
Parents usually transfer cash or investable securities into the custodial account at its very beginning.
The child is named as the only owner on the custodial account’s records, but the money cannot be used until they reach a certain age or meet any other stipulations laid out by the custodial agreement.
After that, parents can transfer money back to their own accounts or have complete control of the funds in the account if they are still minors.
Or, if the child is over the age requirement, the child may have full control of the account and all future deposits and withdrawals, including the ability to invest it however they want.
In cases where the child dies before reaching the age of majority, the money will be included in the child’s estate.
Types of Custodial Accounts
There are two main types of custodial accounts: the Uniform Transfers to Minors Act (UTMA) accounts and the Uniform Gift to Minors Act (UGMA) accounts.
Both accounts are placed under the minor’s name with an elected custodian which can be the minor’s parent or another eligible guardian.
The difference between the two accounts is mainly on the type of assets that it can hold. Only South Carolina in all of the U.S. states does not allow UTMA accounts while UGMA accounts are allowed by all states.
Uniform Transfers to Minors Act (UTMA) Account
UTMA accounts are more flexible in that they may have any variety of assets invested in. It may include cash, real estate, or intellectual property.
Uniform Gift to Minors Act (UGMA) Account
On the other hand, UGMA accounts are more restricted since only financial assets like cash, bonds, annuities, and insurance policies may be invested in.
Why Should I Open One?
If you have children and want to help them get a head start on their adulthood, you may want to consider setting up a custodial account.
It will allow you to help them make wise financial decisions and potentially save and invest their money while they’re still young.
You can also take advantage of the account’s tax benefits, such as its tax-deferred accumulation while it’s in an account with a custodian and capital gains exemption while it is invested in UGMA accounts.
Also, with custodial accounts being so flexible, they could be a great way to introduce your children to investing while providing them security and liquidity if needed.
How to Set Up a Custodial Account
The first step is deciding which type of custodial account you want to set up, either UTMA or UGMA.
Next, check with your state on the requirements of setting up a new account and select the kind of assets you wish to invest in.
Then, find an approved custodian who will help manage the funds for your child until they reach adulthood.
Now, fund the account with either cash or assets, and be sure to file all relevant transactions and paperwork with your state’s financial regulatory office.
Pros and Cons of Custodial Accounts
Like any other account, custodial accounts also have a good balance of risks and benefits. Here are some of it:
Pros of Custodial Accounts
One advantage is that custodial accounts allow parents to give their children a head start on saving money while young. This can help teach them about responsible spending while at the same time earning interest or other returns on their money.
Also, custodial accounts are very flexible in that parents can place any type of asset into them. This includes cash, stocks, bonds, real estate, and intellectual property (such as gold). Custodial accounts may also be tax-advantaged depending on whether they are UTMA or UGMA accounts.
Custodial accounts also do not require fixed or stated contributions and it imposes no withdrawal penalties, as well.
Additionally, although a guardian is mandated to act as fiduciary to the account of the minor, there are no set restrictions as to the usage of the funds. It is not restricted solely for educational expenses and may be used for any reason such as basic living expenses as long as it is always intended for the benefit of the minor.
Cons of Custodial Accounts
On the other hand, custodial accounts do have some disadvantages.
For one, you relinquish all your parental rights and duties while a third party is designated as a fiduciary of the account. Although you may still be able to communicate with them about transactions, it can be inhibited if requested by your child.
Custodial accounts may also affect a minor’s qualification for financial aid since it represents a parental asset.
Ultimately, custodial accounts are a great opportunity for parents to help their children get a head start on their adult lives.
By allowing you to choose what kind of investments go into the account, you can teach your child about smart money management and investment at an early age.
However, it is important to note that custodial accounts also come with some risks and disadvantages such as limited parental rights, and their effect on financial aid eligibility.
As such, it is best to discuss your options thoroughly before setting up a custodian account for your child.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.