Understand the pros and cons of a custodial account

Building a nest egg for the next generation obsesses many parents. One key tool in wealth-accumulating and -preserving comes in two little words: custodial account.

A custodial account is simply an investment account that's in a child's name but managed by an adult. It offers considerably more flexibility than other traditional child-oriented savings and investment options (think 529 plans and education savings accounts). Like a trust, another go-to, generational-transfer vehicle, it keeps control in the hands of a parent, grandparent, or guardian — but is much cheaper and easier to create.

Custodial accounts do come with caveats — the chief one being the child gets to take over the account upon becoming a legal adult, which means having control of a potentially big sum at a pretty tender age (18 or 21).

Here's everything you should know about custodial accounts.

What is a custodial account?

Strictly speaking, any account opened and operated on behalf of someone by another responsible party — a fiduciary, bound to act in the account owner's best interests — can be considered a custodial account.

Fast fact: 401(k) plans are technically custodial accounts, with the employer and the plan administrator acting as custodian for the employees.

But most people use the term to mean a financial account that an adult controls for a minor, typically a child or grandchild. This adult acts as the account custodian — that's why the name "custodial account" — for the minor, who is the beneficiary and technical owner of the account.

Custodial accounts for minors come in two varieties. The main difference involves the types of assets each can hold.

• Uniform Gift to Minors Act (UGMA) accounts can hold most types of financial assets, including things like cash, stocks, bonds, annuities, and insurance policies. But they are limited to these liquid assets. All 50 US states allow UGMA accounts.
• Uniform Transfers to Minors Act (UTMA) accounts can hold any sort of asset. That includes alternative investments like real estate, intellectual property, artwork, and collectibles. South Carolina is the only state to not allow UTMA accounts.

Take note: Though often lumped together, a custodial account is not quite the same thing as a guardian account. Owners/beneficiaries of guardian accounts can include minors but are also often adults who are unable to manage their money due to mental or physical disabilities. Setting up a guardian account requires a court order with specific instructions around the management of the account and its funds.

How to open a custodial account

Parents, grandparents, and guardians can establish custodial accounts at banks, credit unions, brokers, and financial services companies — both the traditional brick-and-mortar kind. These financial institutions set the terms of the accounts: initial investment requirements, minimum account balances, interest rates, management fees. Usually, these terms are pretty much the same as that of any of the firm's regular accounts.

Anyone — parents, relatives, friends — can put any amount of money into a custodial account. Because of gift-tax laws, many do cap contributions at $15,000 ($30,000 for married couples) per child per year.

Whatever the amount, custodial account contributions are irrevocable. Once money goes into a custodial account, it can't be taken back. Even if the child dies before reaching legal adulthood, the account is disbursed as part of the child's estate.

Quick tip: Custodial accounts are usually regular brokerage or bank accounts, funded with after-tax dollars. You can set up a custodial account as a traditional or Roth IRA. But then contributions will be limited to the amount of earned income a child makes each year.

Benefits of custodial accounts

Compared to other savings and investment options, custodial accounts offer a number of advantages, including:

• Efficiency: Custodial accounts are easy to establish — much easier and cheaper to set up than, say, trusts (another common vehicle for transferring funds and saving money in a minor's name).
• Flexibility: There are no income or contribution limits to custodial accounts and no penalties for early withdrawals or restrictions on funds use, as there are with education savings accounts (ESAs) and 529 plans.
• Estate planning: Because it's an irrevocable gift, money or assets put into a custodial account effectively leaves the contributor's estate — which can lessen their income or estate taxes. Because the legal owner of a custodial account is a minor, account earnings are reported as the minor's income. Under IRS rules, a minor's income is taxed at a lower child rate than that of adults (up to a certain amount — $2,200 in 2021).
• Variety: Custodial accounts can trade or hold any asset or investment offered through the financial institution. Only exception: Because of their fiduciary responsibility, many institutions won't let these accounts hold more speculative investments, like futures or derivatives. Trading on margin (borrowing money to buy stocks) is usually out, too.

Downsides of custodial accounts

Although plenty of upside exists with custodial accounts, it's worth remembering some of the downsides as well. These include:

• Financial aid: Custodial accounts are considered the child's property — and assets. Minors with substantial means quickly fall off the list of students who'll receive financial aid. Say goodbye to prospects around grants and low-cost student loans.
• Lack of tax breaks: While custodial accounts include tax advantages, they also exclude other tax benefits. Contributions to custodial accounts don't come with deductions when it comes time to file taxes. When a custodial account kid becomes an adult, they'll owe taxes on any realized account gains at their regular tax rate too.
• Irrevocable: A custodial account legally belongs to its beneficiary — the child. Once they come of legal age, they get full control of it, and can use the proceeds however they wish — no matter what parents intended.

The financial takeaway

Savvy elders consider custodial accounts as a cost-effective and streamlined method to begin building a nest egg for a child.

A custodial account, which amounts to an adult-controlled investment account in a child's name, offers considerably more flexibility than other savings and investment accounts, like ESAs.

Any amount of money can be put into a custodial account, transferred from an adult's accounts (and out of their estate). As easy to set up as any bank or brokerage account, custodial plans offer an economic alternative to the expensive and time-consuming process of establishing a trust.

But custodial account contributions, like the account itself, are irrevocable. While parents enjoy near limitless management for years, eventually the account comes under the child's control, at the legal age of adulthood in their state.

So use the custodial account not only to build wealth for your children, but to teach them some financial responsibility as well.

This article was written by Romona Paden from Business Insider and was legally licensed through the Industry Dive publisher network. Please direct all licensing questions to legal@industrydive.com.