What is a Custodial Account?

At its simplest form, a custodial account is a financial tool that allows adults to manage assets for minors until they reach adulthood. These accounts offer a means for parents, guardians, or other adults to save and invest for a child’s future, providing a structured approach to financial growth and education. 

Anyone considering opening a custodial account for someone in their lives should know that, as well as many benefits, they come with a handful of important considerations, making it essential that you understand how they work, the differences in their types, and potential drawbacks involved.

How does a custodial account work?

A custodial account operates under the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA). These accounts allow a minor to receive gifts or transfers of assets, which are managed by a custodian until the minor reaches the age of majority, which is 18 in Texas.

When setting up a custodial account, the custodian (often a parent or guardian) is responsible for managing the account. This includes making investment decisions and ensuring the assets are used in the best interest of the minor. The custodian has a fiduciary duty to act prudently and responsibly, keeping the minor’s financial growth and stability in mind.

Funds in a custodial account can be used for a variety of purposes, including educational expenses, extracurricular activities, or other costs that benefit the child. For example, similar to 529 plans, custodial accounts could potentially be put toward a college fund for grandchildren or children. However, the assets ultimately belong to the minor and must be transferred to them once they reach adulthood. At that point, the child gains full control over the account and can use the funds as they see fit.

Read more about the tax benefits of a 529 plan in Texas

Types of custodial accounts

There are two primary types of custodial accounts: UGMA accounts and UTMA accounts. Each type has distinct features and benefits, and therefore caters to different financial needs and goals.

UGMA accounts

UGMA accounts allow minors to own securities, such as stocks, bonds, and mutual funds. These accounts are relatively straightforward and offer a way to transfer financial assets to a minor without needing a formal trust. UGMA accounts are limited to financial assets, making them ideal for those looking to manage investments and cash for a child’s future needs.

UTMA accounts

UTMA accounts are more flexible, permitting the transfer of a broader range of assets, including real estate, intellectual property, and works of art. This versatility makes UTMA accounts suitable for families with diverse assets who wish to pass on various types of property to their children. UTMA accounts can accommodate more complex needs (e.g. estate planning solutions), and provide a way to manage a wider array of assets on behalf of a minor.

Both UGMA and UTMA accounts share similarities, such as the custodian’s responsibility to manage the assets and the eventual transfer of ownership to the minor upon reaching the age of majority. The choice between UGMA and UTMA depends on the types of assets you plan to transfer and your long-term financial goals for the minor.

What are the disadvantages of a custodial account?

While custodial accounts offer several benefits, they may not always be the best way to transfer assets from parent to child; there are also some disadvantages to consider before setting one up. Understanding the custodial account rules for adults to follow can help you make an informed decision about whether a custodial account is the right financial tool for your family.

• Loss of control. One of the primary disadvantages is the loss of control over the assets once the minor reaches the age of majority. At that point, the custodian must transfer ownership, and the now-adult beneficiary can use the funds without any restrictions. This can be a concern if the custodian worries about the minor’s ability to manage a large sum of money responsibly.
• Impact on financial aid. Assets held in custodial accounts are considered the child’s property and can significantly impact their eligibility for financial aid. When applying for college financial aid, these assets are factored into the Expected Family Contribution (EFC), potentially reducing the amount of aid the student qualifies for. This consideration is crucial for families planning to rely on financial aid for higher education expenses.
• Tax implications. Custodial accounts also come with tax implications. The minor is responsible for paying taxes on the income generated by the assets in the account. While the first $1,100 of unearned income is typically tax-free, and the next $1,100 is taxed at the child’s rate, any income above this amount is taxed at the parent’s rate (known as the “kiddie tax”). This can lead to higher tax liabilities than if the assets were held in the parent’s name.
• Irrevocable nature. Once assets are transferred into a custodial account, the transfer is irrevocable. This means that the custodian cannot change their mind and withdraw the assets for their own use. This irrevocable nature requires careful consideration and planning to ensure that transferring assets into a custodial account aligns with the family’s long-term financial goals.

How to open a custodial account

​​Opening a custodial account involves several steps, starting with selecting the right type of account and custodian. Here’s a brief overview of the process:

1. Choose the type of custodial account: Decide whether a UGMA or UTMA account best suits your needs. Consider the types of assets you plan to transfer and your long-term financial goals for the minor.
2. Select a custodian: The custodian will manage the account until the minor reaches adulthood. This individual should be responsible, financially savvy, and have the child’s best interests at heart. Custodial accounts are not inherently advisor-managed accounts, but a custodian can benefit greatly from working with a financial advisor.
3. Open the account: You can open a custodial account at most financial institutions, including banks, brokerage firms, and credit unions. The process typically involves completing an application and providing the minor’s Social Security number and other identifying information.
4. Fund the account: Once the account is open, you can transfer assets into it. This can include cash, stocks, bonds, and other eligible assets. Keep in mind that the transfer is irrevocable, so ensure you are comfortable with the decision.
5. Manage the account: The custodian is responsible for managing the assets in the account, making investment decisions, and ensuring the funds are used for the minor’s benefit. Regular monitoring and prudent management are essential to maximize the account’s growth potential.

Wonder if a custodial account is right for your child? Avidian Wealth Solutions can help.

What is a custodial account? In short, it’s a parent/guardian-managed savings account designed to bolster a child’s financial footing when they come of age.

At Avidian Wealth Solutions, we understand the complexities of setting up and managing custodial accounts. Our team of experienced financial advisors can guide you through the process, helping you choose the right account type, select a suitable custodian, and manage the assets effectively.

For more information on custodial accounts and how Avidian Wealth Solutions can assist you, please contact us today. Our team is here to help you navigate the intricacies of custodial accounts and make informed decisions that benefit your family’s financial future.

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