Many parents want to set their kids up for financial success. One of the best ways to do that is to invest money on their behalf. Although there are many different investment accounts to choose from, consider opening a custodial account for your child.
What is a custodial account?
A custodial account is a type of account you can open to invest money on your child’s behalf. Technically speaking, there are two main types: A UGMA (Uniform Gift to Minors Act) and a UTMA (Uniform Transfer to Minors Act). With a UGMA, you can invest money in securities like stocks and bonds on their behalf. With a UTMA, you can invest in securities like stocks and bonds along with additional things like real estate or even put tangible assets like properties and businesses in your child’s name. A UTMA allows you to do everything that UGMA does, plus more. (UTMA’s are not offered in every state so some people are limited to a UGMA).
How does it work?
You call up a financial institution, like Fidelity, Vanguard, TD Ameritrade, etc, and let them know you want to open a custodial account for your child. The account will be in your child’s name and you will be the “custodian” or the person controlling the account. You then put as much money as you want into the account as often as you’d like to invest. Once your child hits the legal age of maturity (which ranges from age 18-21, depending on the state) they get all the money in the account. Some states like Florida, give you the option to delay the age in which your child gets the money until age 25, if you want.
What are the advantages?
It allows you to invest money for your child. By investing money, instead of merely saving it, you will be able to stack up more money for your child over time. If you saved $25 a month for your child starting from the time they were 5 years old, by the time he or she turned 21 you would have stacked $4,800. However, if you had instead invested that money (in index mutual funds which make an average of 10% per year) by the time your child turned 21, he or she would have $10,780. That is more than double what you would have if you only put the money in a savings account!
It provides more flexibility than other investment accounts. Unlike other investment accounts that you can open for your child (like a 529 account or a Roth IRA), with custodial accounts there is no rule on what your child can or cannot spend the money on. If they decide to go to college, they can use it for college. If they want to open a business, they can use it for that. If they want to spend ½ of it to buy a home and the other ½ to pay for their wedding or fund a travel experience overseas they can do that too. It’s your child’s money to do as he or she wishes.
There is no contribution limit. With a custodial account there is no income limit on who can and cannot contribute to the account (like there is with an Educational Savings Account) and there also is no limit to how much or how little you can put into the account each year (like there is with a Roth IRA). It doesn’t matter if you are rich, poor, or somewhere in between, anyone can contribute any amount of money to a custodial account as frequently or infrequently as they want on behalf of their child. Contributions over $15,000 per year will trigger the federal gift tax, but technically speaking you can put as much money in the account as you want. That is not the case with some of the other investment accounts.
What are the drawbacks?
Like almost any type of account, there are things to be cautious of if you decide to open a custodial account on behalf of your child:
The money is your child’s to keep and you can’t take it back. If you are in a financial bind and need money for an unexpected car repair or to repay debt, you cannot withdraw money from the custodial account to do so. When you contribute money to the account you are legally giving the money to your child. This means you cannot take the money back later if you want to. It belongs to your child.
Your child can spend the money on whatever he/she wants. Once your child hits the legal age of maturity, it is their money to spend how they want. While this gives them lots of flexibility, it can be problematic without the right discipline. You may want your child to spend the money on college expenses or a home down payment but he or she may instead choose to spend the money on a fancy car, blow the money on drugs and clubs, or lose it all gambling.
You have to report it on your tax forms and any financial aid forms for school. Since it’s an investment account that makes money, technically speaking, your child must pay taxes on the profit made from investing in the account. Any profits made in excess of $2100 per year is taxed at your (the parent’s) income tax rate. You can choose to pay taxes on your child’s behalf. You can also minimize any taxes owed by investing in low-cost index funds and simply waiting until your child reaches the legal age of maturity to sell any investments. However, if your child goes to college, he or she will have to report any assets they have (including money in this custodial account) to the school which may decrease how much financial aid he or she is eligible for.
Given the drawbacks is it still useful?
Many people think so, but that’s a personal decision that you have to make for yourself. If you know your child will blow the money on drugs and parties then perhaps a custodial account isn’t the best place to invest the money. If you aren’t sure if your child will go to college or anticipate they may need money to pay for a wedding, buy a car, or start a business in the future, then perhaps a custodial account is a good place to invest money.
If you invest money in a custodial account then realize that your child wants to go to college (or think they may be irresponsible with the money in the custodial account) you can use the money to pay for college directly or transfer money from the custodial account into a 529 college account in their name. My point? Custodial accounts can be useful and you can invest in them in addition to other investment accounts like a 529 college savings account or a Roth IRA.
Tell me, would you consider opening a custodial account for your child?