Custodial brokerage accounts can help you set your child up for financial success. Unlike a savings account you might open for your child, these brokerage accounts allow your kid to benefit from the wealth-generating potential of the stock market. And unlike 529 accounts, which generally also provide some exposure to the markets, custodial brokerage accounts can be used to fund much more than just education.
They work similarly to an investment account that you would open for yourself. But they have their own rules and regulations. Here’s what you need to know.
Parents, guardians, friends and family members can all put money into a child’s custodial brokerage account. But only the person who set up the account (the custodian) can choose how that money is invested.
Unlike 529 accounts, custodial brokerage accounts come with no contribution limits, meaning you can invest as much money as you’d like for your child’s future. That said, those who make large gifts may face gift taxes each time their contributions to any one recipient exceed $15,000 in a year.
If you give more than $15,000 (or $30,000 as a couple) to any one recipient, you may incur a gift tax. These taxes are generally charged to the giver, not the recipient. Be sure to check with your financial advisors or tax professionals to determine if you may incur a gift tax.
Although the account is the property of the child, the custodian is responsible for managing it. If you’re the custodian, you will be responsible for filing tax forms on your child’s behalf for any gains and ensuring taxes are paid. As long as you’re still the custodian, the first $1,100 of any investment income may be tax-exempt annually (as of 2020), and the next $1,100 is often taxed at the child’s tax bracket (generally 10 to 12 percent). But once gains reach about $2,200, your child will be taxed using brackets and rates for trusts and estates—which may actually be higher than the parents’ tax rates. This is referred to as the Kiddie Tax.
But there’s one big caveat: Gains are only taxed when they are realized, or when investments are sold. If you’re investing for your child’s long-term future, you probably won’t be selling assets for years or decades. So any annual gains would generally just come from interest or dividend payments, the small regular bonuses some companies or funds give shareholders as a thank you.
While different investments offer different dividend payout rates, you’d generally need a sizable balance before your child’s custodial account produces enough taxable income to reach even the $1,100 threshold. Once ownership of the brokerage account is transferred over to your child—typically when he or she is 18 or 21, depending on the state—your child will typically be taxed at normal capital gains tax rates for withdrawals, based on his or her income bracket.
One exception: Children under 19 years old—or 24, for full-time students—who file as part of their parents’ tax return can avoid paying taxes on the first $1,100 of investment gains, even after they’ve assumed ownership of the account. The next $1,100 would be taxed at the child’s bracket (as of 2020). Unearned income of more than $2,200 would be taxed at the parents’ rate. There may be exceptions that can vary from situation to situation and state to state. Please consult with your financial adviser or tax professional regarding your specific situation."
Custodial brokerage accounts function much like regular brokerage accounts. This means you have access to the same array of investment options, from exchange-traded funds (ETFs) and mutual funds to individual stocks. You can also opt for predesigned diversified mixes, like those you’d find in an Acorns portfolio.
As custodian, you are in control of your child’s custodial account until he or she reaches your state’s age of majority. Depending on your state of residence, this is normally 18 or 21, though certain states may allow you to select an even later age for your child to take control of the custodial account.
While the prospect of an 18 or 21-year-old suddenly becoming in charge of an investment portfolio can seem scary, you can use the years leading up to their adulthood to help them develop good money habits and a healthy relationship with spending and saving, such as teaching them how to create a budget.
All money put into a custodial brokerage account becomes irrevocably your child’s. That means you can’t withdraw money for your own personal use after you’ve contributed it. While you can technically withdraw money from a custodial account before your child reaches the age of majority, you can only do so for the direct benefit of the child. That means any purchases must be to help your child, like buying new school clothes or braces. Keep in mind that any funds you take out may also create taxable gains for your child, and that withdrawn money won’t have as much time to grow.
Custodial brokerage accounts don’t come with the same kinds of limitations as 529 accounts, which can only be used to finance educational expenses. Once a child assumes ownership of his or her custodial brokerage account, he or she can use the money for anything—from educational expenses to a down payment on a home. Before your child takes control of the custodial account, you can withdraw and spend the money you invest in it in any way that directly benefits your child.
Because all money contributed to a custodial brokerage account becomes irrevocably the beneficiary's, you cannot transfer funds or accounts from one child to the next. This is in contrast to 529 accounts, which can be transferred among family members and can even be used for a parent’s own educational expenses.
Because any assets held in a custodial brokerage account are legally your child’s, they weigh more heavily in the Free Application for Federal Student Aid (FAFSA) calculations. Funds held in 529 accounts are considered less heavily. Keep in mind, though, that even money in a child’s savings or checking account is weighed more heavily than funds in a 529 plan.
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