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Pros & Cons of Custodial Accounts for Minors

Establishing an investment account for your minor child offers a tax-efficient strategy for preparing for their future expenses, such as college tuition or other financial needs. A straightforward approach to invest on behalf of your child involves initiating a custodial account under the Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA).

These accounts can be found through various financial institutions like banks, brokerage firms, and mutual fund companies. They possess a unique structure where ownership lies with the child while day-to-day management remains in the hands of the parent or another responsible adult until the child reaches the age of majority, typically around 18 or 21 years old.

Custodial accounts offer a convenient means of transferring assets to a minor without the complexities, expenses, and time commitments associated with setting up a trust. However, it’s essential to note that they also come with certain drawbacks. Let’s take a closer look at the pros and cons.

Pros Of Custodial Accounts For Minors

Convenience and efficiency. Establishing a custodial account is like opening a bank account. So, it’s quicker, easier, and cheaper to set up and maintain than more complex vehicles, such as trusts.

Flexibility. Unlike some savings vehicles, such as Coverdell Education Savings Accounts (ESAs), anyone can contribute to a custodial account, regardless of income level. In addition, there are no contribution limits. Also, there are no restrictions on how the money is spent. In contrast, funds invested in ESAs and 529 plans must be spent on qualified education expenses, subject to stiff penalties on unqualified expenditures. (However, beginning in 2024, limited amounts held in a 529 plan may be rolled over to a Roth IRA for certain beneficiaries.)

Variety of investment options. Custodial accounts typically offer a broad range of investment options, including most stocks, bonds, mutual funds, and insurance-related investments. UTMA accounts may offer even more options, such as real estate or collectibles. ESAs and 529 plans often have more limited investment options.

Estate and income tax benefits. Gifts to a custodial account reduce the size of your taxable estate. Keep in mind, however, that gifts in excess of the $17,000 annual exclusion ($34,000 for married couples) may trigger gift taxes or may tap some of your lifetime gift and estate tax exemption. Contributions to custodial accounts can also save income taxes: A child’s unearned income up to $2,500 per year is usually taxed at low rates (income above that threshold is taxed at the parents’ marginal rate).

Cons Of Custodial Accounts For Minors

Other vehicles offer greater tax benefits. Although custodial accounts can reduce taxes, ESAs, and 529 plans allow earnings to grow on a tax-deferred basis, and withdrawals are tax-free provided they’re spent on qualified education expenses. In addition, 529 plans allow you to accelerate five years of annual exclusion gifts and make a single tax-free contribution of up to $85,000 for 2023 ($170,000 for married couples making joint gifts).

Impact on financial aid. As the child’s property, a custodial account can have a negative impact on financial aid eligibility. ESAs and 529 plans are usually treated as the parents’ assets, which have less impact on financial aid eligibility.

Loss of control. After the child reaches the age of majority, he or she gains full control over the assets and can use them as he or she sees fit. If you wish to retain control longer, you’re better off with an ESA, a 529 plan, or a trust.

Inability to change beneficiaries. Once you’ve established a custodial account for a child, you can’t change beneficiaries down the road. With an ESA or parent-owned 529 plan, however, you can name a new beneficiary if your needs change and certain requirements are met.

Weigh your options

A custodial account can be an effective savings tool, but it’s important to understand the pros and cons. We can help you determine which tool or combination of tools is right for you given your financial circumstances and investment goals. Contact us.

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