Banking services come in a range of types and sizes, and custodial accounts are a key service that you should have a good understanding of if you are taking charge of a minor or young person.
But exactly what are these accounts, and why can they be useful? Below, we take a closer look at everything that you need to know.
An introduction to custodial accounts
A custodial account is a financial account established for the benefit of a minor, often managed by a parent or guardian. It serves as a vehicle to hold and manage assets, such as money, investments, and securities, on behalf of the child. Custodial accounts are typically governed by the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA), varying by state.
These accounts offer a way to transfer assets to a minor while maintaining legal control until the minor reaches the age of majority. The custodian — usually a parent — manages the account, making investment decisions and withdrawals in the child’s best interest. Once the minor reaches the age of majority, the account ownership is transferred to them, allowing them to utilise the assets for various financial purposes.
Custodial accounts can hold a variety of assets, including cash, stocks, bonds, and mutual funds. They offer potential tax advantages and are a popular method for parents and guardians to provide for a child’s future financial needs, such as education expenses or other significant life events.
Below, we put the microscope on the world of banking services and custodial accounts, and the facts that you will need to know when you are seeking to make the right choice of custodial account.
The essentials of custodial accounts, college savings accounts, and trusts
In order to really understand custodial savings accounts, one needs to understand how they differ from some of the other popular financial options when it comes to savings for minors.
All three examples provide a means of transferring money and savings to a minor, but each has its own unique features, pros and cons.
College savings accounts
As the name suggests, college savings accounts are designed specifically for saving for college. To put it bluntly, the money cannot be used for any other expenses, such as medical costs or the purchase of property. This means students can be reassured that they will have the funds they need for their further education.
Custodial accounts – the focus of our discussion here – can be used to save money for a minor, with the intention that these funds will be gifted to the recipient once they come of age. The difference here is that the money can be used for any purpose – not just a college education.
This means that the recipient can use the cash for a downpayment on a house, the purchase of a new vehicle, or even travel. Once the minor reaches adulthood, the money is theirs to do as they please with – and this can have pros and cons.
Both custodial accounts and dedicated college accounts have legislation surrounding them. This means that there are clear, standard templates to use, which makes them much easier to set up.
A trust is a more complex, involved financial option, and the money stored can be used for any person of any age – this type of account is not limited to children or young people.
One of the key differences here is that trusts are their own unique legal entity, and the money can be irrevocable (that is, cannot be retrieved) or revocable (meaning, it can be retrieved as required).
Trusts also allow limits and conditions to be put on the funds. So, you can state what the money must be used for, and set time limits on when it can be used. On the downside, they tend to be tricky and expensive to set up.
A rundown of the different types of custodial account
There are three main types of custodial account, and these are:
- Uniform Transfers to Minors Act (UTMA)
A UTMA account can hold most types of assets. This can include less obvious assets such as artwork, intellectual property, or real estate.
- Uniform Gift to Minors Act (UGMA)
A Uniform Gift to Minors Act account is designed to hold assets that take the form of cash and investments. This can include mutual funds, as well as stocks and bonds.
- Coverdell Education Savings Account (ESA)
An ESA account is funded entirely by cash, and this is normally used for school-related expenses that are required by minor beneficiaries. Funds can only be used to cover expenses that are related to school or education.
What are the benefits of custodial accounts?
There are a number of advantages that can come with a custodial account, and these include:
- They are easy to set up
One of the main benefits of these types of accounts is that they are easy and quick to set up. They can be opened by any mutual fund company, financial institution, or brokerage business. All that is needed to get started is the basic personal information and details of the child, and their assigned custodian.
- They are flexible
Custodial accounts also have the benefit of being super flexible. They can be used for any expenses that the child may incur, such as any educational or medical expenses.
- They are cheap to set up
Unlike trusts, which can be expensive and time-consuming to set up, custodial accounts do not come with any complicated administration costs or set-up fees. This helps to make them a more affordable option for many individuals.
- They keep money safe and secure
One of the main functions of a custodial account is to keep the money of a minor safe and secure until they reach an appropriate age. Put simply, this type of account does the job that it is set up to do very effectively.
- Tax benefits
If you are in charge of a custodial account, you will be in a position to take full advantage of the gift tax exclusion for the period that you are in control of the amount in the account – as long as the money spent and invested is only for the benefit of the child.
Are there any downsides to custodial accounts?
As with any type of bank account or financial decision, it is important to have a good understanding of the potential downsides that may be involved with a custodial account. Some of the main things to be wary of include:
- You lose control when the minor reaches the age of majority
It is important to understand that any deposits made to the account are irreversible, and cannot be retrieved by you once they have been deposited. When the minor named on the account reaches the age of majority, they will inherit the entire contents of the account, and the guardian will lose any control of or access to the funds.
This can be an issue if you have invested large amounts of money, as you will have no legal grounds to recover this. It also means that you will have no other control over what the money is spent on once the minor reaches the age of majority.
Regardless of whether you fear the given young person is going down the wrong path or that the money will be spent unwisely, you will no longer have a say after the minor transitions into adulthood.
- Custodial accounts can have an impact on financial aid prospects
Many college students rely on financial aid to help them finance and get through college, but having a custodial account in their name can have a negative impact on their applications. This is because the account, and the money in the account, are considered to be an asset, and the minor will be eligible for a reduced amount of financial aid.
Provided that you have adequate funds in the custodial account to cover the costs of college, this will not be a problem. However, many potential students find themselves in a position where the money that they have saved in a custodial account is not enough to cover college, but the existence of these funds means they are eligible for a reduced amount of financial aid, and this can put them in a tricky position.
- Reduced tax deal
Although there are tax advantages to a custodial account, these are relatively limited compared to other types of accounts. Moving money to an eligible 529 plan will be a smarter move if you are especially concerned about saving on tax.
Custodial accounts can be a great option to keep finances safe and secure for minors and young people, setting up a nest egg for their future that can be extremely valuable.
By having a clear understanding of what is involved in a custodial account, and the alternative options available, you will be in a position to make smart, informed financial decisions that are in the best interests of the minor in question.