What Is a Custodial Account?

What Is a Custodial Account?

The term custodial account generally refers to a savings account at a financial institution, mutual fund company, or brokerage firm managed by one person for the benefit of another. Generally, an adult controls a custodial account for a minor (a person under the age of 18 or 21 years, depending on the laws of the state of residence). Approval from the custodian is mandatory for the account to conduct transactions, such as buying or selling securities.

In a broader sense, a custodial account can mean any account maintained by a fiduciarily responsible party on behalf of a beneficiary, such as an employer-based retirement account handled for eligible employees by a plan administrator. A fiduciary is bound ethically and legally to act on the best behalf of another's interests.

Each state has specific regulations governing the age of majority and the naming of custodians and alternative custodians.

How a Custodial Account Works

Once established, a custodial account functions like any other account at a bank or brokerage. The custodian—a designated manager or investment advisor—decides how to invest the money. The account manager—or other entities—can continue to contribute to the fund.

As noted above, custodial accounts can invest in a variety of assets. However, the financial institution probably won't allow the manager to use the account to trade on margin or buy futures, derivatives, or other highly speculative investments.

Once the minor reaches the legal age of adulthood in their state, control of the account officially transfers to the named beneficiary from the custodian, at which point they claim full control and use of the funds. Should the minor die before reaching the age of majority, the account will become part of the child's estate.

Types of Custodial Accounts

Custodial accounts come in two basic varieties: the Uniform Transfers to Minors Act (UTMA) accounts and the older Uniform Gift to Minors Act (UGMA) accounts. Their main distinction lies in the kind of assets you can contribute to them.

UTMA accounts can hold virtually any kind of asset, including real estate, intellectual property, and works of art. UGMA accounts are limited to financial assets of cash, securities—stocks, bonds, mutual funds—annuities, and insurance policies. Every U.S. state allows UGMA accounts. However, South Carolina and Vermont don't allow UTMA accounts.

Both UTMA and the older-version UGMA have custodial accounts set up in the minor's name, with a designated custodian—usually the child's parent or guardian. Initial investments, minimum account balances, and interest rates vary by the company that houses the account.

Advantages and Disadvantages of Custodial Accounts

There are advantages, including tax advantages, for custodial accounts. But there are also downsides, including the risk that the account will limit the amount the child can access in financial aid in college because it's considered an asset owned by the minor.

Advantages of Custodial Accounts

Custodial accounts have enormous flexibility. There are no income or contribution limits, and no requirements to make regular distributions at any point. Also, there are no withdrawal penalties.

While all withdrawn funds are restricted to being used "for the benefit of the minor," this requirement is vague and isn't limited to educational costs, as with college savings plans. The custodian may use the funds for everything from providing a place to live to paying for clothing, as long as the beneficiary receives a benefit.

Tax Advantages

While not tax-deferred like IRAs, custodial accounts have some tax advantages known as the kiddie tax. The IRS considers the minor child the owner of the account, so the earnings are taxed at the child's tax rate up to a certain point. Every child under 19 years old—24 for full-time students—who files as part of their parent's tax return is allowed a certain amount of "unearned income" at a reduced tax rate.  

For 2024, the first $1,300 of unearned income is tax-free, the next $1,300 is subject to the child’s tax rate. Then anything over that amount may be subject to the parent's tax rate. However, once the minor reaches the age of majority in their state of residence, they can file a tax return. At this age, all account earnings will be subject to the beneficiary's tax bracket at the filing age. 

Also, an individual can contribute up to $18,000 for the 2024 tax year without incurring the federal gift tax.

Disadvantages of Custodial Accounts

A minor's ownership of the custodial account can be a double-edged sword. Because the holdings count as assets, they may reduce a child's financial aid eligibility when they apply for college. It could also reduce their ability to access other forms of government or community aid.

Any deposit or gifts made to the account are irrevocable, meaning they can't be changed or reversed. All the account's holdings pass, irrevocably, to the minor at the age of majority. In contrast, many college savings plans, such as a 529 account, allow parents to retain control of the funds.

Custodial accounts aren't as tax-sheltered as other accounts. To mitigate a tax bite, a custodian can transfer education funds to an eligible 529 plan. However, to do so, the custodian must liquidate any non-cash investments in the custodial account.

Also, the custodial account beneficiary can't be altered, whereas, the beneficiary on a 529 college plan may change, with some limitations. A custodial account is set up in the minor's name. Because the account is irrevocable, the beneficiary of the account may not change, and no gifts or contributions made into the account can be reversed.

Examples of a Custodial Account

Most brokerages, both digital and brick-and-mortar, offer custodial accounts. Custodial account terms usually parallel those of their regular, non-tax-advantaged accounts for individuals.

For example, a Merrill Edge—the digital broker platform from Merrill Lynch—UGMA/UTMA custodial account can be set up online with funds directly transferred from a checking or savings account at Bank of America, Merrill's parent company. There are no annual account fees or minimum investment amounts.

You can also open custodial deposit and checking accounts at most bank branches.

The Bottom Line

A custodial account is a means by which an adult can open a savings account for a child. The adult who opens the account is responsible for managing it, including making investment decisions, and deciding how the money is to be used, as long as it benefits the child in some way. There are specific tax advantages to a custodial account, but there are also risks, such as the possibility that the existence of the account limits the amount of financial aid a child might get for college. Weigh the pros and cons before deciding to open a custodial account.