Understand the pros and cons of a custodial account
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.
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.
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.
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.
Compared to other savings and investment options, custodial accounts offer a number of advantages, including:
Although plenty of upside exists with custodial accounts, it's worth remembering some of the downsides as well. These include:
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.
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