A custodial account is a savings account at a bank or other financial institution that one person manages for the benefit of another. While many people think of a parent managing a savings account for their minor child, a custodial account can refer to any account in which a responsible person is bound by their fiduciary duty to manage the account on behalf of a beneficiary. For example, your employer’s plan administrator may manage your retirement account on your behalf.
How does a custodial account work?
Every state has its own laws dictating the definition of majority, whether it is 18 or 21, as well as the selection process for custodians and alternative custodians.
If you are the custodian for your minor children, you can open a bank or brokerage account for their benefit. As custodian, it is your fiduciary duty to determine the investment strategy for the account’s funds.
Once your minor child reaches the age of majority established by your state, ownership and control of the custodial account pass to them. Your child can decide how they will invest or spend the money.
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What is a fiduciary duty?
A fiduciary duty is defined as a legal and ethical responsibility to act in the best interests of another. If you have a custodial bank account for your minor child, you have a responsibility to invest their money wisely. You must take reasonable care and be diligent in your responsibilities when making financial decisions for your beneficiary.
If there is a conflict of interest between the custodian and the beneficiary, the custodian has a legal and ethical responsibility to put the needs of their beneficiaries ahead of their own.
Fiduciaries have the following duties:
- Duty to exercise reasonable care and diligence when making decisions for beneficiaries.
- Duty to prioritize the needs of the beneficiary before their own needs.
- Duty to act with honesty and integrity.
- Duty to maintain confidentiality.
- Duty to act prudently and be aware of the risks when making a decision.
- Duty to be transparent.
What are the main types of custodial accounts?
There are two main types of custodial accounts. These accounts can be established at almost any brokerage, mutual fund company, or other financial institution. To keep the account open, the financial institution or broker may have rules regarding custodial accounts, such as the initial investment amount, interest rates, and minimum account balances.
Uniform Gift to Minors Act (UGMA) accounts
UGMA accounts can hold a wide variety of assets, including real estate, intellectual property, valuables, and artwork. You can make unlimited contributions, but if you exceed $18,000 (2024), the gift tax may apply.
Uniform Transfers to Minors Act (UTMA) accounts
UTMA accounts are designed to hold financial assets, including cash, securities, annuities, and insurance policies. Unlimited contributions are allowed, but contributions over $18,000 (2024) may trigger the gift tax.
Other types of custodial accounts include retirement accounts and tax-advantaged education savings accounts, such as 529 plans and Coverdale savings accounts.
What are the advantages of a custodial account?
Custodial accounts are extremely flexible, simple to open, and inexpensive to establish. These accounts do not have contribution limits, required distributions, or withdrawal penalties.
You can use a custodial account to cover any expenses as long as they benefit the minor child beneficiary.
Custodial accounts also come with some tax advantages. The Internal Revenue Service (IRS) considers the minor child to be the owner of the custodial account. For UTMA and UGMA accounts, the first $1,300 in unearned income will be tax free in 2024. The next $1,300 is taxed at the child’s tax rate. Income over $2,600 is taxed at the parent’s tax rate. These rules apply to any beneficiary or child under the age of 18, as well as full-time students up to the age of 24.
Once the child beneficiary reaches the age of majority, their unearned income will be taxed according to the beneficiary’s tax bracket.
What are the disadvantages of a custodial account?
Compared to a trust or other estate planning options, the biggest drawback of a custodial account is that the account holder loses all control over the money and assets in the account. Any money or assets deposited into the account are irrevocable. They pass on to the beneficiary when they reach the age of majority, and the parent or custodian cannot rescind them.
Unlike other educational savings plans, such as a 529 plan, custodial accounts are not tax-exempt. And because custodial accounts are considered the student’s assets, the value of the account may reduce your child’s eligibility for financial aid for college and government aid.
Custodial accounts have many advantages, but they are not the ideal way to transfer wealth from one generation to the next. Talk with your fee-only financial advisor to develop a comprehensive investment plan. Financial planning firms in NYC, like Frame Wealth Management, can guide you in integrating custodial accounts into a broader wealth transfer strategy.
There is no one-size-fits-all guide to investment. Working with a wealth manager who uses a fee-only financial planning structure can ensure you make the best financial decisions for yourself and your loved ones. Ready to secure your financial future? Call us today at 866-395-1786 to get started.
