Interested in teaching a child or grandchild about saving and investing? You might consider setting up a custodial account for them while they are minors. It can help impart the basics of financial planning and investing and instill the importance of long-term thinking, since starting early is so crucial to achieving financial goals.

Generally, a custodial account is a savings account at a financial institution, mutual fund company or brokerage firm that an adult controls for a minor. Although the account is set up in the name of the minor beneficiary, approval from the custodian is mandatory for conducting transactions.

The main benefit of a custodial account is that its assets are taxed at the rate applicable to the minor, not the custodian. Assets in the custodial account are turned over to the control of the minor once they reach maturity—age 18 to 21 depending on the state—or at age 24 if the beneficiary is still a student.

Types of Custodial Accounts

If set up with a broker, the custodial account works like a regular brokerage account. The availability of specific features will be determined by the brokerage company the account is set up with, such as Charles Schwab.

Across the board, there are two federal laws that serve as adoptive models for states to following in governing the gifting and transfer of assets from adults to minors. The first is the Uniform Gifts to Minors Act (UGMA), which all states and jurisdictions have adopted in some form.

UGMA allows donors to make gifts to minors that are free of tax burdens, specifically gifts of cash and securities—the latter of which may include annuities and insurance policies. However, states have individually amended the original uniform model of the law over time, so there may be some variance.

The Uniform Transfers to Minors Act (UTMA) offers states an expanded approach to the variety of assets that can be transferred to a custodial account for the benefit of the minor. This act covers any kind of property, real or personal, tangible or intangible, such as real estate and art.

UTMA incorporates the provisions of UGMA, but the former is only effective in states that have adopted it. While all 50 states have adopted some form of UGMA, South Carolina and Vermont are states that have not adopted UTMA in any capacity.

Custodial Accounts Versus Qualified Tuition Plans

When deciding if a custodial account is the best option for gifting assets to minors, it is important to consider 529 college savings plans, also known as qualified tuition plans. If the end goal of the money gifted and invested on behalf of the minor beneficiary is specifically for use toward paying for higher education, a custodial brokerage account may not be the best option.

The benefits of qualified tuition plans vary depending on the state and the type of plan. The most important difference between a qualified tuition plan and a custodial brokerage account is that assets held in a custodial brokerage account count as assets in the minor beneficiary’s name. Assets in a qualified tuition plan are considered to belong to the parent.

A minor’s ownership of the custodial account can be a disadvantage. Because the holdings count as assets, they may reduce a child’s financial aid eligibility when they apply for college. This also applies to the child’s ability to access other forms of government or community aid.

Tax Advantages of Custodial Accounts

Although custodial accounts are not tax-deferred like IRAs, they do have their own tax advantages. Since the IRS considers the minor the owner of the account, the earnings in the account are taxed at the child’s tax rate up to a certain level.

Individuals can contribute up to $16,000 in a single year to a custodial account before the contributions become subject to a gift tax based on 2022 limits. Parent or grandparent spouses can each contribute up to $16,000 for a total of $32,000. Contributions over these limits will be taxed at the donor’s tax rate. (The gift tax exclusion is subject to annual inflation adjustments.)

Custodial accounts are also subject to the kiddie tax, which applies to unearned income above a set threshold from a minor’s assets. This tax is designed to prevent parents from exploiting a child’s account to avoid paying taxes on assets at their own rate.

The annual limit for the 2022 kiddie tax is $2,300. The first $1,150 of unearned income is covered by the kiddie tax’s standard deduction and the next $1,150 is taxed at the child’s marginal tax rate. Anything above the $2,300 limit is taxed at the parent’s tax rate, or whoever has claimed the minor as a dependent. The kiddie tax exemption is indexed to inflation.

General Usage Stipulations of Custodial Accounts

A custodial account is an irrevocable gift and must be turned over to the child when they reach the age of maturity. However, custodial accounts have enormous flexibility because they carry no limits on contributions or income and carry no requirements to make regular distributions. There are also no withdrawal penalties.

Keep in mind that the custodial account beneficiary cannot be changed.

Any funds used prior to the age of maturity must be used for the sole benefit of the minor. Technically, custodial accounts grant more freedom in the employment of gifted assets compared to a qualified tuition plan, since assets set aside for later education must be used as such. The definition of “used for the sole benefit of the minor” is far vaguer and open to potential interpretation.

Custodial accounts generally allow investment in a variety of assets. For example, in Charles Schwab’s custodial brokerage accounts the custodian can buy and sell stocks, mutual funds, exchange-traded funds (ETFs) and other securities. However, certain features may not be available, such as trading on margin or buying futures, derivatives or other highly speculative investments.

Weigh the Pros and Cons of a Custodial Account

A custodial account is a means by which an adult can open a savings or investment account for a child. The adult who opens the account is responsible for managing it by making investment decisions and deciding how the money should be used, as long as it benefits the child in some way. But custodial accounts can provide an excellent way to introduce a child to finance and investing concepts and allow them to experience the gratification of seeing assets grow.

There are tax advantages to a custodial account, but there are also disadvantages, such as the potential for the assets in the account to limit the amount of financial aid a child is eligible for. Weigh the benefits and risks before opening a custodial account.