Custodial Accounts and Financial Education

Definition and Key Concepts

A custodial account is an investment account held by an adult (custodian) on behalf of a minor (beneficiary) under the Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA). The assets legally belong to the child, but the custodian manages the account until the child reaches the age of majority (18-25, depending on state).

Custodial accounts provide a mechanism for transferring wealth to children while introducing them to investment concepts through real account ownership. Unlike 529 education savings plans, custodial accounts have no restrictions on how the funds can be used once the child gains control.

UGMA vs. UTMA comparison:

Key characteristics of custodial accounts:

• Irrevocable gifts: Once assets are deposited, they cannot be taken back by the donor
• Child's property: Assets legally belong to the child, not the custodian
• Mandatory transfer: Custodian must transfer control when the child reaches termination age
• No contribution limits: No annual maximum (though gift tax rules apply above $18,000/year per donor in 2024)
• Taxable account: Investment gains are subject to income tax under kiddie tax rules

How It Works in Practice

Opening a Custodial Account

Requirements:

• Custodian must be a legal adult (18+)
• Beneficiary must be a minor (under 18 or 21, depending on state)
• Social Security numbers for both custodian and beneficiary
• Initial deposit (typically $100-$1,000 minimum, depending on brokerage)

Common brokerage options:

Account titling format:

"[Custodian Name] as Custodian for [Minor Name] under the [State] UGMA/UTMA"

Example: "Maria Rodriguez as Custodian for Sofia Rodriguez under the California UTMA"

Understanding the Kiddie Tax (2024 Rules)

The kiddie tax prevents parents from shifting investment income to children in lower tax brackets. For children under 19 (or under 24 if full-time students), unearned income above certain thresholds is taxed at the parent's marginal rate.

2024 Kiddie Tax thresholds:

Calculating taxable income:

A custodial account with $20,000 invested in a total stock market index fund generating 2% in dividends ($400/year) and with $1,500 in realized capital gains:

• Total unearned income: $400 + $1,500 = $1,900
• First $1,300: Tax-free
• $1,300 - $1,900 ($600): Taxed at child's rate (10%) = $60 tax
• Total tax owed: $60

Investment strategy implications:

• Keep unrealized gains intact to defer taxes until after age 24
• Growth-oriented investments (low dividends) minimize annual kiddie tax exposure
• Total stock market index funds typically distribute 1.5-2% in annual dividends
• A $25,000 account generating 2% dividends ($500) remains below the $1,300 threshold

Custodial Roth IRA Option

If the child has earned income (from a job, business, or paid chores), a Custodial Roth IRA provides tax-free growth with no kiddie tax concerns.

Custodial Roth IRA rules (2024):

• Contribution limit: Lesser of $7,000 or child's earned income
• Child must have documented earned income (W-2 or self-employment)
• Contributions can be withdrawn tax-free at any time
• Earnings grow tax-free and are not taxed upon qualified withdrawal after age 59.5

Example:

A 15-year-old earning $3,000 from a summer job can contribute up to $3,000 to a Custodial Roth IRA. If invested at 7% annual return for 50 years (until age 65), that $3,000 becomes $88,134 tax-free.

Using Custodial Accounts for Financial Education

Educational activity 1: Account access and review

Starting at age 10-12, give children view-only access to their custodial account. Review the account together quarterly:

• Current balance and change from last quarter
• Individual holdings and their performance
• Explanation of why the account goes up and down with the market

Educational activity 2: First investment decision

When the child is 12-14, involve them in choosing a new investment for a portion of the account. Present two or three options and discuss:

• What does each fund invest in?
• Why might one outperform another?
• What are the risks?

Let the child make the final selection for a small portion ($100-$500). This creates ownership over the investment outcome.

Educational activity 3: Understanding dividends and gains

When dividends are paid, show the child the dividend statement:

• How much was paid
• What the money represents (share of company profits)
• That dividends can be reinvested automatically (DRIP) or taken as cash

For capital gains, demonstrate how selling at a higher price than purchase price creates a gain (and tax liability).

Educational activity 4: Tax return involvement

Starting at age 14, involve the child in preparing the tax forms related to their custodial account:

• Form 1099-DIV for dividends
• Form 1099-B for capital gains
• Form 8615 for kiddie tax calculation (if applicable)

Walk through how unearned income is taxed and why investment placement matters.

Worked Example: The Johnson Family Custodial Strategy

Family profile:

• Parents: Combined income $145,000, 22% marginal tax bracket
• Child: Emma, age 10
• Grandparents: Want to contribute to Emma's future

Account establishment:

• Account type: UTMA (California, terminates at age 21)
• Custodian: Mother (Sarah Johnson)
• Initial deposit: $5,000 from grandparents
• Brokerage: Fidelity (no minimums, no commissions)

Investment allocation:

Year 1 tax implications:

• Dividends received: $65
• Capital gains realized: $0 (no selling)
• Total unearned income: $65
• Tax owed: $0 (below $1,300 threshold)

Ongoing contribution plan:

• Grandparents: $2,000 annually (birthday and holiday gifts)
• Parents: $1,200 annually ($100/month)
• Total annual additions: $3,200

Projected growth (7% annual return):

At age 21 (UTMA termination), Emma receives full control of approximately $75,000.

Educational timeline:

Kiddie tax management:

At $75,000 balance with 1.5% dividend yield, annual dividends would be $1,125. This remains below the $1,300 threshold, resulting in $0 tax. If dividends exceed $1,300, the family would:

1. Consider tax-loss harvesting to offset gains
2. Shift toward lower-dividend growth investments
3. Accept modest tax at child's rate for amounts between $1,300-$2,600

Risks, Limitations, and Tradeoffs

Risk 1: Loss of Control at Termination

When the child reaches the UTMA/UGMA termination age (18-21), they receive full, unrestricted control. A child could spend the entire balance on non-constructive purposes.

Mitigation: Begin financial education early. By age 18, the child should have years of experience with the account. Discuss expectations before termination. Consider a 529 plan instead if you need to ensure funds are used for education.

Some states allow UTMA termination at age 21 or 25, providing more time for maturity. California, for example, allows specifying ages up to 25.

Risk 2: Financial Aid Impact

Custodial accounts are considered the student's asset, assessed at 20% for FAFSA Expected Family Contribution (EFC) calculations. This is significantly higher than the 5.64% rate for parent assets.

Calculation example:

• $50,000 in custodial account: Increases EFC by $10,000 ($50,000 x 20%)
• Same $50,000 in parent-owned 529: Increases EFC by $2,820 ($50,000 x 5.64%)

Mitigation: If financial aid is a priority, consider spending down custodial accounts before college (on qualifying pre-college expenses like a computer, books, or first-year college costs paid before FAFSA is filed). Alternatively, use 529 plans instead of custodial accounts.

Risk 3: Irrevocable Nature

Once funds are deposited, they cannot be withdrawn for parental use. Even in financial hardship, the custodian cannot reclaim the money.

Mitigation: Only deposit funds you are committed to gifting permanently. Maintain separate emergency savings for family needs. Start with smaller amounts and add over time rather than making large initial deposits.

Risk 4: Kiddie Tax Complexity

Managing the kiddie tax requires tracking unearned income and potentially filing additional tax forms (Form 8615).

Mitigation: Keep custodial account investments in low-dividend, growth-oriented funds to minimize annual distributions. Avoid frequent selling that realizes capital gains. Use tax-advantaged accounts (Custodial Roth IRA) when the child has earned income.

Next Steps

1. Determine the appropriate account type for your situation: UTMA for maximum flexibility, 529 for education-specific goals with better financial aid treatment, or Custodial Roth IRA if the child has earned income

2. Select a brokerage with no account minimums and commission-free ETF trading (Fidelity, Schwab, and Vanguard are common choices for custodial accounts)

3. Open the account with an initial deposit between $500 and $5,000, invested in a low-cost total market index fund to minimize dividend distributions and kiddie tax exposure

4. Create an educational timeline appropriate to your child's age, beginning with account awareness (ages 10-12), progressing to quarterly reviews (ages 12-14), and including the child in investment decisions and tax preparation (ages 14-18)

5. Document your contribution plan specifying annual amounts from parents and grandparents, ensuring total gifts per donor stay below the $18,000 annual gift tax exclusion (2024)