As a parent, you want to make sure you’re setting your kids up for all the success you can. Part of that is providing for them financially while they’re under your roof. Another is laying the groundwork for them to thrive when they’re on their own.
Some people do this through savings accounts earmarked for their kids or 529 accounts, though these come with their own limitations. Savings accounts generally offer much lower returns than you might expect from investing in the stock market—in fact, they may not even keep up with inflation (the rate at which prices increase).
While 529 accounts offer exposure to the wealth-generating potential of the stock market, they come with some constraints, namely that they can’t be used for anything outside of education without incurring penalties.
Another option for forward-thinking parents: the custodial brokerage account.
Definition of a custodial account
Custodial brokerage accounts allow you to invest for your children in much the same way you invest for yourself. With a custodial brokerage account, you and friends and family can contribute money toward your child’s future that you can then invest in the same kinds of stocks, bonds, mutual funds and exchange-traded funds (ETFs) you might in your own Individual Retirement Account (IRA) or brokerage account. You may also be able to invest in precrafted and managed portfolios of investments, like those offered by Acorns.
Unlike traditional brokerage accounts, custodial brokerage accounts do come with a few restrictions. The big one is that, depending on your state of residence, ownership transfers automatically to your child when he or she turns 18 or 21 (or later, if the state allows you to elect a later age). Before then, funds cannot be taken out unless they are used to directly benefit the child. You also may not be able to contribute more than $15,000 a year before you incur a gift tax. And any investment income (like dividends, interest or earnings) that are generated in the account is considered the child's and taxed.
Custodial brokerage accounts may be classified as UGMA (Universal Gift to Minors Act) or UTMA (Universal Transfer to Minors Act) accounts. These classifications refer to the laws that allow you to give assets to your children.
Why open a custodial account for your child?
You may have heard the expression that it’s time in the market, not timing the market, that really matters. When you start investing early, you harness the power of time to optimize your investing results.
Over time, gains made on your investments compound, meaning their returns get returns of their own, and so on and so on. That’s the power of compounding in action. Start investing even a small sum after your children are born, and you could give them the gift of 18 years of compounding or more.
What’s the difference between a custodial account and a traditional brokerage account?
Traditional brokerage accounts and custodial brokerage accounts both allow you to invest for your child through stocks, bonds, mutual funds and ETFs and other investments. Money from each can be used for education or for a myriad of other purposes (once your child takes ownership of the custodial account), but the two differ in a few key ways:
You control the money in a traditional brokerage account
When you invest for your child in a brokerage account in your name, you can access funds at any point in time. You can also choose when or if to gift money to your child. Control of a custodial brokerage account, on the other hand, automatically transfers to your child at 18 or 21 depending on your state of residence. (Some states may also allow you to elect a later age.)
There is no maximum to the amount you can contribute annually to traditional brokerage accounts
Unlike custodial brokerage accounts or even 529 accounts, you can invest as much as you wish in traditional brokerage accounts. Keep in mind that should you eventually gift money in this account to your child, you may want to do so over time. The same gift tax restrictions may eventually apply.
Traditional brokerage accounts offer no tax advantages
While custodial brokerage accounts are still subject to taxes on any investment gains, the first $1,100 may be tax exempt annually. The next $1,100 is often taxed at the child’s tax bracket (generally 10 percent). Once gains reach about $2,200, they 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.
What’s the difference between a custodial account and a 529 account?
If investing for children is on your radar, you might be most familiar with 529 accounts, a special type of investing account that offers tax advantages for those investing for children’s college expenses. Both custodial brokerage accounts and 529 accounts let you invest for your children’s future—and both can be used for educational costs. But they have a few important differences:
529 accounts offer tax advantages
These include potential income tax deductions (depending on your state of residence) and tax-free growth (if used toward educational expenses). Funds held in custodial brokerage accounts, on the other hand, may result in your child owing income taxes, depending on the amount of money they earn in a given year.
529 account funds can only be used for educational expenses
While 529 accounts can be a great option for college savings, you’ll incur a 10 percent penalty (plus may owe income taxes) on any amount you withdraw that isn’t used for educational expenses. “Educational expenses” has broadened to include forms of education outside of college or university, like trade schools.
But any uses outside of even this expanded definition may incur taxes or penalties. Funds held in custodial accounts can be used any way your child wishes after he or she takes ownership. Before that, you can use them in any way that directly benefits your child, like for school expenses or clothing.
529 account funds can be used by other family members
Even though there is one named beneficiary on a 529 account, the account holder can change this to another family member, like a sibling or even one of the parents themselves, should a child choose not to use the 529 funds. Custodial brokerage accounts, conversely, become the designated child’s irrevocably and cannot be used even by a parent in any way except to benefit the child directly.
Your child’s financial aid might be affected by a custodial account
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.
What are the benefits of opening a custodial brokerage account?
You and others, including family and friends, can invest in your child’s future
Custodial brokerage accounts let you and others contribute money to your child that you can then invest on their behalf. Depending on the amount, some might be subject to gift tax. While you can normally give up to $15,000 a year without incurring a gift tax, check with your tax professional or financial advisor for more information.
You probably have access to a broader range of investment options
One of the chief complaints with 529 accounts is the comparative lack of investment options available. Instead of being able to invest in hundreds (or thousands) of different stocks, bonds and exchange-traded funds (ETFs), for example, you may be limited to a handful of target-date funds or mutual funds. Custodial brokerage accounts, on the other hand, offer similar investment options to what you might have access to in your own brokerage account.
You won’t pay taxes on money held in your child’s account
Though custodial brokerage accounts don’t offer quite the same tax advantages of 529 accounts, they aren’t without any potential tax benefits. Any dividend or investment income made in a custodial brokerage account is technically your child’s investment income and would need to be reported as such. When they have small balances, that could mean this income sees little to no taxes.
What else should you consider with a custodial brokerage account?
Your child will gain control of the account at 18 or 21
In most cases, once your children turn 18 or 21, total control reverts to them. That means they can continue investing in it, they can liquidate it immediately or they can withdraw from it regularly over time. This is unlike 529 plans, which parents control and can even use for education for other family members or themselves.
Any contributions are irrevocably your child’s
As soon as money hits your child’s custodial brokerage account, it’s theirs. Although that doesn’t mean you can’t withdraw it, it does mean you can only do so for expenses that directly benefit your child. This could be anything from rent to clothing for your child. While this isn’t as limiting as the 529 account requirement that funds be used for education, it’s not as restriction-free as a brokerage account held in your own name.
Your child might owe taxes
You may get a slight tax break when you put money into a custodial brokerage account (versus having it grow in your own account), but your child might be on the hook if they make more than $1,100 in investment income. They might face even higher taxes once that amount exceeds about $2,200. Check with your tax or financial professionals for more information about how your child’s custodial brokerage account might be affected by taxes.
Investing involves risk including loss of principal. This article contains the current opinions of the author, but not necessarily those of Acorns. Such opinions are subject to change without notice. This article has been distributed for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.