Parents and guardians eager to set their children on a path toward financial independence might consider a custodial investment or brokerage account. Like traditional brokerage accounts, many of these investment tools provide a way to buy and sell stocks, bonds, exchange-traded funds (ETFs), and other instruments. Because minors are not eligible to open their own brokerage accounts, parents and guardians can open and manage custodial accounts in a child's name.
Teaching children about how to manage, save, invest, and spend money may help them to establish and enjoy a solid financial future. Custodial accounts provide an excellent way to explore the principles of investing with a child and can be an important part of a foundational financial education.
This article examines the different types of custodial brokerage and investment accounts available for parents and guardians to open on behalf of their children. It then takes a look at how to choose a brokerage firm, how to open the account, and how to manage and fund the account.
Key Takeaways
- Opening a custodial brokerage account allows parents or guardians to introduce children to investing at an early age.
- Factors to consider when selecting a brokerage firm for a child’s account include fees, investment options, and educational resources.
- The process of opening a custodial account involves providing personal and banking information and completing a series of forms online.
- Funding options for custodial accounts include cash, stocks, and mutual fund transfers.
- Teaching children about investing involves educating them about long-term financial planning and involving them in the investment decision-making process.
Understanding Brokerage Accounts for Children
A custodial account is one that allows a minor to own assets in a brokerage account while at least one parent or guardian manages and controls the account until the child reaches the legal age of majority. Although the child does not manage the account, the assets in the account do belong to the minor, and capital gains related to the account are taxed in the child's name.
There are a variety of different types of custodial accounts available. While most custodial accounts share these characteristics, there are important distinctions among them as well, including varying requirements and restrictions. Below is an overview of several of the types of custodial investment accounts for minors.
Custodial Brokerage Accounts
A custodial brokerage accounts is a type of investment account with few restrictions regarding income and contribution limits, distributions, and withdrawal penalties. The custodian makes all investment decisions related to the account until the minor reaches the age of legal majority (typically either 18 or 21, depending upon the state), at which point the minor claims full control of the account and use of the funds.
There are two primary types of custodial brokerage accounts:
- Uniform Transfers to Minors Act (UTMA) accounts, which may hold virtually any type of asset, from traditional investment vehicles to alternative investments such as real estate, works of art, precious metals, and more.
- Uniform Gifts to Minors Act (UGMA) accounts, which are limited to holding cash, stocks, mutual funds, and insurance policies.
Friends and family may contribute up to $17,000 in 2023 ($18,000 in 2024) free of gift-tax consequences to a child's UGMA/UTMA account. Couples can contribute $34,000 in 2023 ($36,000 in 2024).
529 Plans
529 plans, also known as qualified tuition plans, are tax-advantaged savings plans specifically set up to save for future education expenses. They are offered by states and vary somewhat depending upon the area you are in. 529 plans are divided into two categories: education savings plans and prepaid tuition plans. These accounts typically permit investment in mutual and exchange-traded funds, as well as some target-date funds, but not individual stocks.
Coverdell Education Savings Accounts
Coverdell education savings accounts function similarly to 529 plans, although they have strict contribution and income limits. The total contribution to any beneficiary may not exceed $2,000 per year. Account holders with modified adjusted gross income (MAGI) of $110,00 or more and account holders married filing jointly with MAGI of $220,000 or more are ineligible for these accounts.
Custodial Roth IRAs
A parent or guardian may assist a child who has begun to work and earn income in opening a custodial Roth IRA account. Both parent and child may contribute to these accounts, but there is a limit of $6,500 in total contributions per child per year for tax year 2023. The contribution limit increases to $7,000 for the 2024 tax year.
Choosing the Right Brokerage Firm
Well-known firms offering accounts for minors include Charles Schwab, E*TRADE, Fidelity, Merrill Edge, and Vanguard.
When selecting a brokerage, parents and guardians should be well aware of the different types of custodial accounts and their various tax implications, contribution limits, and other restrictions.
Even within a single type of custodial account, different brokerages may offer a variety of fees, investment options, and educational resources, so it is well worth the time to shop around.
Opening a Custodial Account
Follow these steps to open a custodial account for a minor.
1. Select a Brokerage and Account
Make the decision about which brokerage and account type is right for your needs, being sure to keep in mind both your current financial situation as well as your goals for your child's financial future.
2. Input Personal and Funding Information
The process of opening the account is usually quick and completed entirely online. You'll need information including Social Security numbers for any account holders and the minor beneficiary, contact information, your employment info, and the identifying information for one or more other accounts to use to fund the custodial account.
3. Fund the Account and Manage the Investments
With the account created, the final step is to fund the account so that there is money to use for investing, and then to manage those investments over time to whatever extent you like as the account holder. Custodial accounts can typically be funded with cash, stocks, or mutual fund transfers.
Tax Considerations for Custodial Accounts
Investment income for assets in many custodial accounts can incur taxes at either the account holder's or the beneficiary's tax rate, depending on the account. In some cases there are also tax implications for contributions made to a custodial account. These tax considerations vary significantly across different types of accounts, so it's essential to know what to expect before you open the account.
For example, UTMA and UGMA accounts are taxable and have no contribution limit. The way that taxes are calculated for these accounts depends on the amount earned, so this is an important consideration to keep in mind when planning how much to invest in any given year. In 2023, for instance, the first $1,250 in annual earnings on one of these accounts are exempt from federal income tax, while the next $1,250 in annual earnings are taxed at the child's rate. The figure increases to $1,300 for tax year 2024.
In the case of a 529, earnings are exempt from federal tax when used for qualified college expenses, although they may be subject to state taxes depending upon your location. Account holders may also face a gift tax consideration if they contribute more than $17,000 to a particular beneficiary in 2023 or $18,000 in 2024.
Contributions to Coverdell accounts are not tax deductible. Distributions from these accounts to their beneficiaries are tax-free, but only to the extent that those distributions do not exceed the beneficiary's qualified education expenses. After this point, distributions are taxable to the beneficiary.
Like Roth IRAs for adult investors, custodial Roth IRA account contributions are not tax deductible. However, distributions made down the line are then not subject to taxes. If you plan to invest a portion of your child's income into a custodial Roth IRA, be sure to keep in mind the tax implications at the time your child earns the income.
Teaching Children About Investing
One of the many advantages of a custodial account is that it provides parents the opportunity to show their children how investing works, to follow and monitor the returns on their investments, and to realize the benefits of compound interest and long-range financial planning. You can even use the account as a way to educate a child about different types of investment vehicles, constructing a balanced asset mix, and other more advanced investment topics.
What Are the Benefits of Opening a Brokerage Account for a Child?
Custodial brokerage accounts for minors provide parents and guardians a way to begin building the child's financial future while overseeing investment activity until the child reaches the age of majority. They can also be a valuable tool in teaching the child about investing.
How Do I Choose the Right Brokerage Firm for My Child's Account?
Before choosing a firm, select the type of account you would like based on your income, expected contribution levels, tax preferences, and financial goals. Among the brokerages providing the account type of your choice, be sure to consider fees, the availability of educational resources, and permissible investment and funding options.
What Documents Are Required to Open a Custodial Account?
Most custodial accounts can be opened in minutes online using personal information for the adult account holder and the minor beneficiary, such as Social Security numbers, contact information, and employment information when relevant. You'll also need to provide information about an account to link to the custodial account for funding purposes.
The Bottom Line
Custodial accounts provide an excellent way for parents to build toward their child's financial future while educating them about the importance of planning and investing. These accounts allow adults to control and manage assets belonging to a child for investment purposes, with all control of the account passing to the beneficiary when they reach the age of majority.
Some of the most popular types of custodial accounts include custodial brokerage accounts, custodial Roth IRAs, UTMA and UGMA accounts, and 529 plans. Most can be opened quickly and online with any number of major brokers.
