Scared Your Child Will Blow Their Savings? Consider a Custodial Account.

I can only imagine what would have happened if my parents would have given me access to a big chunk of money when I was still young.

I used to be really good at blowing my money on crap that I didn’t need, so I’m sure anything they would have saved would have been gone in an instant.

Sound familiar for any of you?

This is just one of the many reasons why custodial accounts were created.

If you’re scared that your child will blow through their savings, here’s what you need to know about custodial account rules.

Basically, a custodial account is established to protect the financial assets given to a minor child. In most cases, the account is created by the child’s parent or legal guardian for one of two functions.

Some custodial accounts can be established to make sure the child has sufficient resources throughout his or her adolescence. Other custodial accounts are created to cover educational expenses after high school graduations.

Additionally, the account can be established to provide a good financial foundation during the child’s adult life.

Custodial Account Rules

While there are multiple reasons that a parent or legal guardian may have to open a custodial account, the process to begin is the same. The account can be opened at a brokerage firm, a mutual fund company, bank or any other type of financial institution. An adult is assigned to manage the account until the child reaches the age requirement for to have full access to the account.

Depending on state legislation, the age range to grant access can be between 18 and 21 years. This is known as the age of majority and the age can be over 21 based on state legislation and specific circumstances.

Additionally, the custodian of the account must approve any transactions that the minor may want to conduct on the account. Investments are allowed but must be limited to mutual funds or similar financial products.

Role of the Custodian

Custodial accounts originated with the Uniform Gifts to Minors Act (UGMA) of 1956 where a custodian is designated to manage the account until the child reaches adulthood. The parent or legal guardian can act as the custodian or name another adult to serve in this capacity. Generally, the custodian’s role is to manage the assets of a custodial account to buy, sell and/or reinvest earnings. If necessary, the custodian can withdraw money from the account when it benefits the child.

The law requires that all assets in a custodial account be used only to benefit the minor child.

Clearly, the expectation is that the custodian will never use the money for personal interests. Paying expenses that are unrelated to the child’s interest is prohibited.

If the custodian is also the legal guardian or parent, they should get expert financial advice on the appropriate use of the funds. There are allowed distributions that may apply. In general, the account cannot be used to pay for daily expenses that the guardian or parent is legally obligated to cover.

What Happens to Investment Income?

The dividends, interest and earnings from investment income is considered income for the child, and the rules around this have recently changed. Currently, when the child is under 18, any unearned income over $2,200 is subject to the “Kiddie Tax”. This rule also applies if the child is under 24 and a full-time student.

Here’s how it breaks down. For the 2020 tax year, the child’s unearned income under $1,100 is not taxed; the next $1,100 is taxed at the child’s tax rate, which can be very low, and any unearned income in excess of $2,200 is taxed at the parents’ tax rate.

Ownership of the Custodial Account

The assets of the custodial account are owned by the child for whom the account was created. While it is true that the child does not control the account until he or she meets the age requirement, the child is the legal owner from the start. Typically, assets are placed into the account as a gift for the child.

Legally, this completes the transaction and a person cannot take the property back at a later date. The same rule applies to any income that generates from the assets, i.e. stocks, mutual accounts.

529 Plans Vs. Custodial Accounts

Establishing savings plans for your kids basically comes down to two options: custodial accounts or 529 plans.  There are many differences between the two, but here’s the main ones I point to people who are interested:

1. With 529 plans, the owner (usually the parent) is always in charge of the money even after the child turns 18.  This is huge for a lot of parents.
2. The 529 plans must be used for college or college related expenses (think room and board, books, supplies). Custodial account has no restriction on what the money can be used for.
3. If the money inside the 529 plan is used for the above mentioned expenses, the owner will not have to pay any income tax when cashing out the funds.
4. Custodial accounts offer a lot more flexibility with the investment choices (brokerage, high yield savings, etc.). 529 plans are usually mutual funds that are pre-selected by the states plan that you choose.

Overall, if saving for college is your prime goal, I would suggest the 529 plan over the custodial account.   If you don’t want your child to feel like the money has to be used for college, then go with the custodial account.

Termination of the Custodial Account

Custodial accounts terminate when the child reaches the specified age according to state law. The type of transfer may also determine when the account terminates. A parent or legal guardian could designate an age that is different from state law.

For example, state law may require account termination when the child turns 18 years old. However, the creator of the account may specify termination at age 21. Once the account terminates, the child has free reign on how to use the assets of the account.

There are also legal guidelines if the child dies before the account terminates. Typically, the custodian cannot allocate how the assets are distributed. The custodial account becomes part of the child’s estate and must be distributed according to estate laws.