Custodial Accounts

What is a Custodial Account?


A custodial account is an investment account setup for the benefit of a minor, but is under control of a parent or guardian.  The basic logic behind a custodial account is that children are too young to manage money and are likely to squander it all away on video games, chocolate and trips to your local shopping mall.  The custodian is responsible for managing the account and determining if needed how funds should be distributed to the minor for their benefit prior to their maturation date (18, 21 or 25 depending on the state).  Once the minor reaches their maturation date, the assets in the custodial account must be transferred over to the minor.  By law the recipient of the funds has full ownership. So, it is a very real possibility that at age 21, if your child is naive, they could still end up blowing the money.  Like any investment vehicle, custodial accounts also come with inherited risks.

History of Custodial Accounts


Custodial accounts are a relatively new concept in finance.  These types of accounts were born out of the Uniform Gifts to Minors Act (UGMA) of 1956.  Custodial accounts provided a means for the "common" man to pass funds over to their children at a later date without the steep legal fees associated with setting up a trust fund.  

Setting up a Custodial Account

Planning for Multiple Children

Most brokerage firms will be able to support setting up a custodial account.  The key thing to remember when setting up an account is that it can only be assigned to one of your children.  This means there is only one social security number tied to one account.  So, if you plan on having kids later, please make sure the accounts are funded equally.  The last thing you want is for Bobby to have 3 times the amount of Susan 20 years from now.


Taxes



As always the IRS wants their cut.  So, what is the smart way for investing in a custodial account without getting hammered?  Well there is a known gift tax pass that the IRS provides for things like a custodial account.  The basic premise is that a set amount of funds can be transferred over to an individual and the recipient does not have to pay taxes if the gift is under a certain dollar limit (i.e. $13k).  This gift tax will come in handy when the grand parents decide they also would like to contribute to Jacob's future.

Returns on Custodial Accounts

While your child is a minor, income generated in the custodial account is still taxable.  The plus for you is that this income will not be added to the custodian's taxable income, but will be taxed at the prevailing child tax rate.


College



When applying for financial aid a portion of the assets from the custodial account is reviewed when determining eligibility.  So, let's say the current law states that 20% of the custodial account assets are accounted for during the application process.  If the total cost for tuition is $100k and the custodial account has $20k, then the student is only eligible for $96k worth of tuition assistance ($100k - (20% of $20k)).  Depending on the size of the custodial account, this could be an issue if the student needs the funds from the custodial account for other financial matters and cannot apply them directly to their college tuition.

Death of Custodian


It is not something we like to discuss, but we must all be prepared for the inevitable.  A simple resolution to your untimely demise is to name another custodian (close family friend, grandparent), that will be responsible for managing the custodial account until the child reaches the designated age.  This way you can avoid the custodial account from being included in your estate and having the courts decide who will manage the account for your child.

Summary


Custodial Account

In summary, any sort of financial planning for your child's future is always a positive.  However, since the age for receiving the funds from a custodial account are still relatively young, things may not go as planned.  A better approach for providing a future financial cushion for your little ones may be 529 plan or setting up a trust.  Something along these lines will still provide a way for helping your children in the future, while still giving you some control on what is done with your hard earned money.

For more information on custodial accounts visit the following external resources:

Custodial Accounts and the IRS
Custodial Account Setup Page at Bank of America

Tim Ord
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