What Is a Custodial Account? Know This Important Piece of Estate Planning

If you’re a parent, we bet you’ve pondered the best ways to build and preserve your child’s wealth, and while there are many different routes you could take, a custodial account is one of the easiest and most economic ways to create a firm financial foundation.

Generally speaking, a custodial account refers to any financial account that an individual opens and maintains for another person. Most often, however, custodial accounts are savings accounts opened by a parent or designated guardian on behalf of a minor (under 18 or 21 years old depending on the state).

Types of Custodial Accounts

When setting up a custodial account, you’ll be able to choose from two basic varieties depending on the types of assets you wish to contribute.

UNIFORM TRANSFERS TO MINORS ACT (UTMA)

UTMA accounts can hold any type of asset, from real estate and intellectual property to artwork and collectables. All states except South Carolina allow this type of account.

UNIFORM GIFT TO MINORS ACT (UGMA)

UGMA accounts are limited to financial assets but can hold virtually any type, including cash, stocks, bonds, and insurance policies. All 50 states allow UGMA accounts.

How Does It Work?

Compared to setting up an individual trust for a child, which can be expensive and time-consuming, a custodial account is relatively easy to set up and run. The adult custodian opens the account and can then add money or select different investments.

One of the biggest advantages of custodial accounts is the ability to invest in just about any asset offered through a given financial institution. However, many institutions will not allow highly speculative investments, such as futures or derivatives. Trading on margin is usually off limits, too.

Once the child reaches a certain age (either 18 or 21), full control of the account must be transferred to them. In the case of the minor’s death, the account becomes part of the child’s estate.

Disadvantages of Custodial Accounts

They could impact financial aid eligibility

Custodial account holdings are considered the minor’s assets. This means minors with substantial funds may become ineligible for financial aid in college. They may also be unable to access other forms of government aid.

They offer minimal tax breaks

While custodial accounts do have some tax advantages, they miss out on the tax benefits associated with other account types. Contributions are not tax-deductible, and the minor who owns the account will also owe taxes on any realized account gains once they become an adult.

They’re irrevocable 

The beneficiary of the account, along with any gifts or contributions, cannot be altered. Other common savings plans, such as 529 plans, allow modifications under certain circumstances.

Advantages of Custodial Accounts

They’re highly flexible

Custodial accounts don’t have income or contribution limits. Additionally, there aren’t any restrictions on fund usage, and there’s no penalty for withdrawing early. You’d incur a 10% fee if you were to withdraw early from a 529 account, for example.

They’re easy and efficient

Compared to other methods of saving money on behalf of a minor, such as setting up an individual trust, a custodial account is easier and less expensive to establish. The process is as simple as setting up any bank or brokerage account.

They offer some tax advantages

The first $1,150 of unearned income is exempt from federal income tax (for 2022), and the next $1,150 is taxed at 10%. While anything above $2,300 is taxed at the parent’s rate, the beneficiary can file their own tax return once they’ve reached the age of majority. All earnings would then be taxed according to the beneficiary’s tax bracket, not the original custodian’s.

They can fit into your estate planning strategy 

Custodial accounts can be a strategic component of your estate planning. Because any contributions made by the custodian are irrevocable, they effectively leave your estate, which can lower your own income or estate tax burden.

If you’re curious to learn more about how a custodial account would align with your unique estate planning goals, contact Ironwood Wealth Management today.