Guide to Custodial Accounts and How They Work

By Marcy Lovitch · October 18, 2023 · 10 minute read

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Guide to Custodial Accounts and How They Work

Many parents want to save for their child’s future. One way to do this is by setting up a custodial account. This type of account specifically allows an adult to put money into a savings or investment account for a minor, which they can then access once they reach adulthood.

Custodial accounts can be a great way to give a child a financial gift. These funds can eventually be used for such expenses as their education, a car, wedding, renting an apartment, or even buying a home. If college is a particular goal, you can even open a custodial account designed for this very purpose.

If you’re considering opening up a custodial account for a young person, read on to learn what a custodial account is, the different types, and how they operate.

What is a Custodial Account?

A custodial account is savings or an investment account, established with a bank, brokerage firm, or mutual fund company, that’s managed by an adult on behalf of a minor, also known as the beneficiary.

Custodial accounts typically allow a parent, grandparent, family friend, or guardian to start saving for the child, until they reach adulthood, which depending on the state of residence, could be 18, 21, or even 25 years of age.

Even though the custodian manages and oversees the funds, the account is in the child’s name. Once the child reaches adulthood, the account legally transfers to their control.

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How Custodial Accounts Work

Opening a custodial account is simple. You can likely start one with almost any financial institution, brokerage firm, or mutual fund company. All a custodian probably needs to establish one is to provide basic personal information about themselves and the child. Once a custodial account is created, the adult can start contributing funds into the account.

The financial institution sets the terms of the account, which may include a minimum balance, maintenance fees, and initial investment requirements, among other stipulations. Individuals can usually contribute as much as they want to a custodial account, but there’s a federal cap on how much you can contribute that’s free of the gift tax imposed by the IRS. In 2023, this amount is up to $17,000 for individuals and $34,000 for married couples per child, per year.

Custodial bank accounts usually come with protections for the beneficiary. While the custodian can withdraw money from the account, legally the money must only be used to benefit the minor. This means the adult in charge of the account can’t use the funds for their own personal reasons. Additionally, any contribution made becomes the property of the child, so transactions can’t be changed or reversed.

A monthly contribution to a custodial account can make a big difference in a child’s life because the money can substantially accumulate over the years. According to Fidelity Investments, starting to contribute $50 a month to a custodial account when a child is 5 years old can result in $21,000 once that child reaches age 21. Put in $150 a month and that amount goes up to $63,000, while $250 a month clocks in at $104,900.

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Types of Custodial Accounts

There are two main types of custodial accounts: the Uniform Gift to Minors Act (UGMA) and the Uniform Transfers to Minors Act (UTMA). While both have the same objective and eliminate the need to start a trust, they work in slightly different ways. Another option is the Coverdell ESA and 529 accounts that can help with saving for college.

Uniform Gift to Minors Act (UGMA)

The Uniform Gift to Minors Act (UGMA), established in 1956, is a custodial account that grants adults the opportunity to give or transfer many different kinds of financial assets to a child. Here’s what is important to know:

•   Besides cash, assets in an UGMA account can include individual stocks, index funds, bonds, mutual funds, and insurance policies.

•   UGMA accounts aren’t limited to educational expenses. In fact, the money can be used by the beneficiary for anything once they come of age. A UGMA doesn’t have restrictions or contribution and withdrawal limits, but, as previously noted, gift tax limits apply.

•   This kind of custodial account is available in all 50 states and is easy to set up at many financial institutions and brokerages nationwide. Keep in mind there may be a minimum deposit required to open an UGMA.

•   There aren’t any tax benefits for contributions, but up to $1,250 of any earnings from a custodial account may be exempt from the IRS, and a portion of up to $1,250 of any earnings greater than the exempt amount may be taxed. If so, it will be at the child’s tax rate, which is generally lower than their parent’s tax rate.

•   Since education costs are one main reason parents or loved ones open a custodial account, one thing to know is because the funds are considered an asset owned by the child, it can affect their ability to get financial aid and student loans.

Uniform Transfers to Minors Act (UTMA)

The Uniform Transfers to Minors Act (UTMA), is a newer, expanded version of an UGMA. There are some differences between them to be aware of:

•   The main difference is that an UTMA account can include physical assets, such as cars, art, jewelry, and real estate.

•   You are not able to open a UTMA in every state. Currently, South Carolina and Vermont are two that don’t allow you to open a UTMA custodial account. And many states have a higher age at which a beneficiary can take control of a UTMA compared to a UGMA account.

•   The zero contribution limits, tax benefits, and financial aid impact that come with UGMAs are the same for UTMAs.

Coverdell Education Savings Account (ESA) and 529 Plans

There are two educational savings plans that fall under the umbrella of custodial accounts and can help a parent save for college for their child. One is the Coverdell Education Savings Account (ESA).

•   This type of custodial account exists solely for saving for a child’s future educational needs. According to the IRS, ESA contributions made must be in cash and are not tax deductible.

•   Unlike UTMAs and UGMAs, there’s a $2,000 limit per year to how much you can contribute to the ESA’s account beneficiary.

•   ESA custodial accounts also have income-based restrictions and are only available to families who fall under a certain income level. Coverdell ESA’s are created by each state so you’ll need to see if your state offers one.

A 529 College Savings Plan, also known as a “qualified tuition plan” is often considered a kind of custodial account because it’s created to pay for the beneficiary’s educational expenses, whether it’s for college, tuition costs for kids in grades K-12, certain apprenticeship programs, and even to pay student loans.

•   Unlike other custodial plans, a 529 College Savings account can remain in the holder’s name even when the beneficiary reaches the age of majority in their state.

•   There aren’t any income limits for a 529 Plan, which differentiates it from a Coverdell ESA.

•   The 529 Plans are state-sponsored and most states offer at least one. You must be a U.S. resident to open a 529 Plan.

•   You don’t have to be a resident of the state and can pick another state’s plan, but your state may offer a tax deduction if you live there and open one. The Federal Reserve features a list of state 529 Plans.

Custodial Accounts vs. Traditional Savings Account

Both a custodial account and a traditional kid’s savings account can be opened with the goal of putting money away for a child’s future. However, they are two separate types of accounts that operate in different ways.

•   A traditional savings account opened for a minor is a type of joint account that typically can be accessed and used by both the minor and their parent or guardian. Some states and financial institutions have age limits or restrictions on whether a child can be on a joint account. With a custodial account, as previously mentioned, a minor can’t make any transactions until they reach the age of maturity.

•   Traditional savings accounts typically have no limits on how much money you can keep in the account, but banks may have a base amount you need to open an account along with minimum balance requirements.

•   Custodial accounts may be better for long-term savings, while a traditional savings account can teach kids about banking and good finance habits.

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Pros and Cons of Custodial Accounts

Custodial accounts have their upsides and downsides. Here’s some pros and cons to consider, presented in chart form:

Pros of Custodial AccountsCons of Custodial Accounts
Easy to set upCustodian loses monetary control when beneficiary comes of age
Can be inexpensive to establishMay have a cap on how much you can contribute due to gift-tax laws
May have tax benefitsNot as tax-exempt as other types of financial accounts
Money is the property of the childCan impact the ability to get financial aid
Anyone can make a contribution to the accountContributions are irrevocable

4 Steps to Opening a Custodial Account

Setting up a custodial account is simple and doesn’t take up a lot of time. Here’s how to open a custodial account in four steps.

1. Decide on the Type of Custodial Account

Research the various options to determine which kind of account would best suit your goals and those of the child. For example, is the goal strictly for educational expenses? Are there limits to contributions? Do you want contributions to include physical assets as well as monetary funds?

2. Figure out Where You Want to Open the Account

Banks, brokerage firms, and mutual fund companies all offer custodial accounts. Pick the one that best suits your comfort level, familiarity, and goals for the child.

3. Gather the Child’s Personal Information as Well as Your Own

When you open the account, you’ll want to have the necessary information ready, such as the custodian and child’s Social Security numbers, addresses, phone numbers, and dates of birth.

The person who will be controlling the account will most likely have to provide employment information and have the account number(s) ready for another bank or investment account they want linked so they can transfer the money between accounts.

4. Open the Account

Many financial institutions make it easy for you to start an account online through their websites, or you can go to the financial institution in person.

The Takeaway

Custodial accounts can be a solid way to sock money away for a child’s future, whether it be for their education, a financial gift, or to provide them with a leg up on savings once they become young adults. These accounts can be opened at financial institutions and banks around the country, and you don’t even need to leave home to set one up. Depending on which type of custodial account you choose, you may also enjoy some tax-advantages too.

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Are custodial accounts a good idea?

They can be. Saving and investing money on behalf of a child can make their lives easier once they’ve become an adult. Having a built-in financial cushion they can use for their education, housing, a trip, or even towards retirement can be a valuable gift to someone as they start their adult life.

How does a custodial account work?

A parent, grandparent, guardian, or loved one can open a custodial account for a child, at a bank, brokerage, or mutual fund firm. The account is for the benefit of the child and managed by an adult or the custodian of the account, with contributions added over time, if desired. Once the child turns 18, 21, or 25 (depending on which state they live in), the money is turned over to them.

What are the pros and cons of custodial accounts?

The advantages of a custodial account are an automatic savings available to the child when they become of age, typically to spend on whatever they want; some potential tax breaks for the person who opens the account; and the ease of setting them up. Downsides of a custodial account include a possible cap on how much you can give because of gift-tax restrictions; the inability to reverse any transaction after its completed; and, since the account is considered an asset of the child, it could affect their ability to be eligible for financial aid when applying to schools.

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