When it comes to raising children, you want to do all you can to help them succeed. Part of that is taking care of their money while living with you. Another is giving them the tools they will need to be successful when they are on their own.
Some people put money away in savings accounts for their kids or in 529 accounts, but these have their limits. Savings accounts usually don’t give as good a return as the stock market.
Even though 529 accounts give you access to the stock market, which has the potential to make you rich, they have some limits. For example, you can’t use them for anything other than education without getting fined.
The custodial brokerage account is another option for parents who think ahead.
What is a custody account?
With a custodial brokerage account, you can invest for your children or other children in your life in a way that is similar to how you invest for yourself. A financial institution can set up a custodial brokerage account for the child. You and your friends and family can then give money to the child’s future. Usually, you can give up to $15,000 a year without paying a gift tax.
The money in the account can usually be put into the same stocks, bonds, mutual funds, and exchange-traded funds (ETFs) that you might have in your own Individual Retirement Account (IRA) or brokerage account. You might also be able to invest in portfolios of investments that have already been made and are being managed.
Custodial brokerage accounts are different from traditional investment accounts in that they have a few rules. The biggest one is that the child automatically becomes the owner when they reach the age of majority, which is the legal age of adulthood. Depending on where they live, that is usually 18 or 21. Before then, the money can’t be taken out unless it’s used to help the child directly.
And the child is taxed on any investment income (like dividends, interest, or earnings) that comes from the account.
Universal Gift to Minors Act (UGMA) and Universal Transfer to Minors Act (UTMA) accounts are two types of custodial brokerage accounts. These groups are based on the laws that let you give money or property to your children.
UGMA accounts vs UTMA accounts
The main difference between UGMA and UTMA custodial accounts is that UGMA accounts can only hold publicly traded financial products like CDs, stocks, bonds, mutual funds, and insurance products. On the other hand, UTMA accounts, first set up in 1986, can usually hold financial products and any property, such as real estate or artwork.
The state in which a child is adopted is another difference between UGMA and UTMA accounts. Every state has signed on to the UGMA. But Vermont and South Carolina are still the only two states that do not allow UTMA accounts.
Why set up a custodial account for your child?
You may have heard the phrase “it’s time in the market, not time in the market” before. When you start investing early, you take advantage of the power of time to get the most out of your investments. This means that your child can benefit from your long-term investments.
Over time, the money you make from your investments compounds. This means that the funds you get back from them give you more money, and so on. This shows how the power of compounding works. Start investing even a small amount after your children are born, and you could give them the gift of 18 years or more of compounding.
Traditional brokerage account vs custodial account
You can invest for your child in stocks, bonds, mutual funds, ETFs, and other things with traditional brokerage accounts and custodial brokerage accounts. Once your child becomes the owner of the custodial account, the money from either can be used for education or several other things. However, there are a few fundamental variances between the two:
You control a standard brokerage account.
You can always get the money when you put money away for your child in a brokerage account under your name. You can also select if and when to give your child money. On the other hand, your child takes control of a custodial brokerage account when they turn 18 or 21, depending on where you live.
Traditional brokerage accounts are tax-free.
Any investment gains in custodial brokerage accounts are still taxed, but the first $1,100 may be tax-free each year. Most of the time, the next $1,100 is taxed at the child’s tax rate (generally 10 percent). Once gains reach about $2,200, they will be taxed using brackets and rates for trusts and estates, which may be higher than the parents’ tax rates. This is also termed the “Kiddie Tax.”
Custodial accounts might affect your child’s financial assistance.
FAFSA gives more weight to assets in a custodial brokerage account because they legally belong to your child. Less weight is given to funds held in 529 accounts.
Benefits of getting a custodial brokerage account
You and others, like family and friends, can put money into your child’s future.
With a custodial brokerage account, you and other people can give money to your child, which you can then invest in. Gift tax may apply to some gifts, depending on how much they are. Most of the time, you can give away up to $15,000 a year without paying a gift tax.
You likely have more access to investing opportunities.
One of the biggest complaints about 529 accounts is that there aren’t many ways to invest the money. You may not be capable of investing in hundreds or even thousands of stocks, bonds, or exchange-traded funds (ETFs). Instead, you might only be able to invest in a few target-date funds or mutual funds. On the other hand, custodial brokerage accounts give you the same investment options as your brokerage account.
The money in your child’s account won’t be taxed.
Even though there aren’t as many tax benefits to custodial brokerage accounts as there are to 529 accounts, there are still some. Any dividends or investment income earned in a custodial brokerage account belong to your child and should be reported. When they have small balances, it could mean that little or no tax is taken out of this income.