Custodial Account

What is a 'Custodial Account'

A custodial account is a savings account accessible through a financial institution, mutual fund company or brokerage firm that an adult controls for a minor under the age of 18, depending on state laws. It can also be a retirement account handled for eligible employees by a custodian. In a custodial account, approval from the custodian is mandatory for a minor to transact securities.

BREAKING DOWN 'Custodial Account'

The custodian of these types of accounts is usually a parent or guardian of the minor. The investments administered in a custodial account are restricted to mutual funds and other comparable products offered by regulated investment companies.

Custodial account minimum account balances and interest rates vary by company. Anyone can contribute to the custodial account. Once the minor reaches adulthood, account ownership transfers from the custodian to the minor. However, once the minor reaches adulthood, the minor can decide when and how to use the money.

There are two types of custodial accounts: the Uniform Transfers to Minors Act (UTMA) and the Uniform Gift to Minors Act (UGMA). The UTMA allows parents to postpone distributions, but age limits vary by state. However, the UGMA allows parents to give funds to their child in the form of money, life insurance, savings bonds, stocks or annuities.

Advantages

There are no income limits, contribution limits or withdrawal penalties. However, any amount over $14,000 is subject to a gift tax. A custodian can transfer funds to an eligible 529 plan. However, the custodian must liquidate any non-cash investments in the custodial account.

Disadvantages

Since the account is treated as an asset, it may reduce financial aid eligibility for a minor. It is best to open a custodial account only if the minor does not qualify for financial aid.

Although withdrawal rules vary by state, they are subject to tax at the minor’s tax rate. Based on the age requirements for the minor, a portion of unearned income is tax-free. The remaining portion is taxable at the child’s tax rate or the parent’s federal tax rate.

Investment earnings are subject to annual federal and state income taxes. Capital gains on funds liquidated in a custodial account are subject to taxes. Gifts made to a custodial account are irrevocable to the minor. In addition, the beneficiary cannot be altered.

Tax Concerns

A parent must file a tax return for her child until the child reaches the age requirement for the transfer of account ownership. Earnings and dividends are subject to tax at the minor’s rate starting at age 18. Minors under the age of 18 are taxed on a specific portion of earnings and dividends on the account, and the remaining portion is subject to tax at the parent’s rate. If the minor earns income, he must file his own return. Depending on the amount of unearned income, claiming the income could move the minor into a higher tax bracket.