A custodial account is a financial account managed by a custodian (usually a parent or guardian) on behalf of a minor. These accounts are created at financial institutions such as banks and brokerage firms. The primary purpose of custodial accounts is to save and invest for the minor’s future, enabling them access to the assets once they reach the age of majority.
Types of Custodial Accounts
Uniform Gifts to Minors Act (UGMA)
The UGMA account is a type of custodial account that allows the custodian to manage financial assets like stocks, bonds, mutual funds, and cash for the benefit of the minor.
Uniform Transfers to Minors Act (UTMA)
The UTMA account extends UGMA by allowing a greater range of assets to be transferred to the minor, including real estate, intellectual property, and other tangible assets.
Special Considerations
Restrictions on Transactions
Minors cannot make securities transactions or withdrawals without the custodian’s approval, ensuring that the account funds are managed responsibly.
Tax Implications
Custodial accounts are subject to the “Kiddie Tax,” which taxes the unearned income of minors at the parent’s higher tax rate if it exceeds a certain threshold.
Examples of Custodial Accounts
Example 1: UGMA Account at a Bank
John’s parents open a UGMA account at their local bank, depositing $10,000. The bank account earns interest and allows investments in stocks and bonds.
Example 2: UTMA Account at a Brokerage Firm
Sarah’s grandmother opens a UTMA account at a brokerage firm, transferring a mix of stocks, cash, and a piece of real estate. Sarah will have control over the assets once she turns 18 (or 21, depending on state law).
Historical Context
Custodial accounts were established to simplify the transfer of assets to minors without needing formal trusts. The UGMA was first enacted in 1956, followed by the UTMA in 1986, broadening the scope of assets that could be transferred.
Applicability
Custodial accounts are ideal for gifting and are often used for saving for education, building wealth, and teaching financial responsibility to minors.
Comparisons
| Feature | UGMA | UTMA |
|---|---|---|
| Assets | Financial assets only | Financial and tangible assets |
| Age of Majority | 18 (or 21, state-dependent) | 18 (or 21, state-dependent) |
Related Terms
Kiddie Tax: A tax rule applied to the unearned income of minors, designed to prevent income shifting from parents to children to exploit lower tax brackets.
Trust Fund: A legal arrangement through which assets are held by a trustee for beneficiaries.
529 Plan: A tax-advantaged savings plan designed to encourage saving for future education costs.
FAQs
What happens to a custodial account when the minor reaches the age of majority?
Can custodial account funds be used for educational expenses?
References
- Internal Revenue Service (IRS), “Topic No. 553 Tax on a Child’s Investment and Other Unearned Income (Kiddie Tax),” IRS.gov.
- Financial Industry Regulatory Authority (FINRA), “Custodial Accounts for Minors,” FINRA.org.
Summary
Custodial accounts are valuable tools for parents and guardians to save and invest for a minor’s future. They offer tax benefits and flexibility in asset management while protecting the assets until the minor reaches the age of majority.
Whether you choose a UGMA or UTMA account, it’s essential to understand the rules, restrictions, and benefits to make informed decisions that best serve the minor’s financial future.
