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Adulthood can be pricey.
According to the U.S. Bureau of Labor Statistics, the average American spent $61,334 on housing, food, entertainment and other expenses in 2020.
If you’re a parent, you might wonder what you can do to help your child thrive once they’re on their own in this expensive world — and one of the best ways to do that is by setting them up with their own nest egg.
Custodial accounts are some of the most powerful tools available for intergenerational wealth transfers.
What is a custodial account?
A custodial account is a savings or investment account managed by an adult (the custodian) for a minor until the child reaches the age of majority. That age varies from 18 to 21, depending on the state.
Once a minor with a custodial account reaches the age of majority, they inherit control of the account and the funds, but their spending may also be restricted, depending on the type of custodial account.
Types of custodial accounts
Many custodial accounts are Uniform Gift to Minors Act or Uniform Transfer to Minors Act accounts. These are taxable brokerage accounts.
UGMA accounts allow adults in all 50 states to give minors cash or securities. UTMA accounts are similar, but they also allow transfers of real estate, art and other assets not permitted in a UGMA account. UTMA accounts are available in every state except Vermont and South Carolina.
» Read more about UTMA and UGMA.
“Most custodial accounts that most advisors set up are that UTMA type of account,” says Rick Nott, a California-based certified financial planner and senior wealth advisor for LourdMurray.
“I’ve facilitated setting up custodial IRAs and Roth IRAs,” Nott says. “You can also set up a custodial 529 account where [a minor] is technically the owner and beneficiary.”
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Custodial account rules
Gift tax rules generally govern contributions to custodial 529 plans and non-education-related custodial accounts.
“Any person can give any other person $16,000 per year without having to file a gift tax return. While you could put more into a custodial account, there’s estate and tax ramifications for doing so,” says Nott.
» Learn more about the gift tax.
Coverdell ESA contributions have their own rules. If you're a single tax filer with a modified adjusted gross income, or MAGI, below $95,000, or a joint filer with a MAGI below $190,000, you can contribute the full amount. If you have a higher MAGI, the amount you can contribute will be reduced. And you can't contribute to a Coverdell ESA at all if you're a single filer with a MAGI above $110,000, or a joint filer with a MAGI above $220,000.
529 plan balances also must not exceed the expected cost of the child’s education; that number varies by state.
Distributions from custodial 529 plans and ESAs must be used for qualified education expenses. UTMA and UGMA accounts have looser distribution rules, but they can’t be used as a piggy bank for the adult custodian.
“You can take out money from a UTMA before the minor reaches the age of majority, as long as it’s used for their benefit. So it can’t be used for the custodian’s own personal use,” says Jeff Weber, a certified financial planner for California-based registered investment advisor Titus Wealth Management.
“Once the minor turns the age of majority, then they have free access to the account. It actually turns into an individual account in their name, and they can withdraw as little or as much as they want at that point in time,” says Weber.
How to open a custodial account
“Anyone can set up a custodial account,” said Nott. “It’s really simple, you can typically do it at banks.”
Many banks and financial institutions allow customers to apply for a custodial account online.
» Check out our roundup of the best custodial accounts.
“You need the name and information of the child, and more importantly you need a custodian, a person who’s effectively controlling the account until [the child] reaches the age of majority. That has to be an adult, 18 years or older,” says Nott.
Custodial accounts and financial aid
If you’re considering opening a UTMA or UGMA account to help pay for a child’s education, you should know that it may affect their financial aid eligibility.
UTMA and UGMA accounts are considered assets that belong to the minor and thus may negatively impact financial aid eligibility through the Free Application for Federal Student Aid.
» Dig deeper into FAFSA.
Custodial 529 plans and ESAs have more favorable FAFSA treatment, as they’re considered assets belonging to the parent. That means they will only reduce the child’s financial aid eligibility by a maximum of 5.64% of the account balance.