What Are Custodial Accounts, and How Do They Work?

Whether your goal is to save for college or just start putting some money away to help your child (or grandchild) in the future, options abound. A variety of long-term savings vehicles, such as custodial accounts, can help. Here’s a closer look at what types of custodial accounts are available and how they work.

What is a custodial account?

Custodial accounts are opened on behalf of a minor. While the child technically owns the assets in the account, the adult serves as the custodian, making decisions, like managing contributions and making investment choices, on behalf of the child. Once children reach the age of majority in their state, they become the owners of the accounts and have full access to do whatever they choose.

Custodial accounts can be structured as regular savings accounts or investment accounts. The latter allows the custodian to invest in stocks, bonds, exchange-traded funds (ETFs), mutual funds and other securities. Thanks to compound interest, starting a custodial account early for your children can help them get a big jump on their own future savings.

What are custodial accounts for?

Custodial accounts are fairly flexible and allow you to save for virtually anything, such as:

• College;

• Setting money aside for a minor’s first car, home purchase or another big-ticket item; and

• Leaving a legacy for your child, grandchild or other minor you care about.

Types of custodial accounts

Custodial accounts come in several shapes and sizes. Here are some common custodial accounts:

1. Uniform Gifts to Minors Act (UGMA)

An UGMA is an account that allows a minor to receive financial gifts from adults. This type of account has no overall contribution limit. Each person who contributes to the account can deposit up to $17,000 per year, which means a couple can contribute up to $34,000 in 2023 without tax consequences. If you contribute more than that, it’ll count toward your lifetime gift-tax exclusion limit. (For 2023, that’s just under $13 million.)

The money you deposit can be used for whatever the child pleases when he or she takes ownership. UGMAs allow you to invest in all sorts of securities, including stocks, bonds and other assets, although there are some limitations.

2. Uniform Transfers to Minors Act (UTMA)

This is an account that’s structured the same way as a UGMA account, with a couple of important differences. Unlike UGMAs, an UTMA account can also hold physical assets—like cars and real estate. Life insurance policies and annuities are typically allowed as well. UTMAs may also allow for a later age of majority, depending on your state and how the account is structured. In most states, the age of majority is 21 (vs. 18 in many states for an UGMA).

3. Coverdell education savings account (ESA)

A Coverdell ESA is a college savings vehicle that allows contributions to grow and be distributed tax-free if the funds are used for qualified education expenses.

These also have some drawbacks, including a cap on annual contributions at $2,000 per beneficiary. You’re also unable to contribute to these if your income is more than $220,000 for married couples filing jointly ($110,000 for single filers). Also, the funds must be used by the time the beneficiary turns 30 to avoid tax consequences.

4. Custodial Roth IRAs

If your child earns income, you can open a custodial Roth IRA for them. This allows you to contribute their after-tax earned income, up to $6,500 per year.

When minors come of age, they’ll take ownership of the accounts and can use the contributions for anything they wish. (Though they may be penalized for tapping any earnings on the account before age 59½.)

How do custodial accounts work?

While each account has its own rules and nuances, custodial accounts are intended as a way to save money for a minor. In each case, adults will control the money on behalf of children until it is spent for their benefit or eventually transferred to them once they become adults.

Part of an adult’s responsibility in managing the account is selecting what assets to invest in and what risk tolerance to carry. For example, because your child is likely not touching funds for a while, you may invest in an asset with a higher investment risk, yet as your child gets closer to potentially using the money, perhaps for something like college, you may want to change the investments to something lower risk.

Withdrawing from a custodial account

With custodial accounts, there are some rules around how you can withdraw and use money that’s in the account.

With UGMA/UTMA custodial accounts, the custodian can make withdrawals as needed before the minor reaches the age of majority. The only stipulation is that the funds must be used to benefit the child.

Withdrawals from a Coverdell ESA are typically penalty-free if they’re used to cover qualified education expenses. Otherwise, you could face penalties on top of a tax bill.

If you’re certain your child will use educational expenses for college, you may consider transferring funds from a custodial account into a 529. The tax advantages of a 529 can be substantial—like tax-free growth and tax-free withdrawals as long as you use funds for qualified education expenses—so they’re a great way to save for college. However, transferring typically involves liquidating the custodial account and putting cash into the 529, so you’ll want to weigh penalties in doing so with what you may gain with tax advantages of a 529.

What happens to a custodial account when a child reaches the age of majority?

Upon reaching a certain age (usually between 18 and 21), minors will take ownership of most custodial accounts. This means they’ll be able to manage the accounts on their own. UGMA/UTMA accounts will then operate like a regular brokerage or savings account. With a custodial Roth IRA, the child (now an adult) will have the option to continue saving for retirement or use their contributions for anything else they like (however, taking distributions of earnings before the child reaches 59½ may result in taxes and a penalty).

Who is liable for taxes on a custodial account?

Children typically file taxes on their parent’s return, so if a child does owe taxes on their custodial account, the parents will be responsible for the taxes.

Different custodial accounts face different tax treatment. For UGMA and UTMA accounts, the IRS views investment dividends and gains as unearned income. If this amount exceeds $1,100, minors will be expected to file a federal tax return. They’ll be taxed on the next $1,100 at their own income tax rate. Unearned income beyond $2,200 is taxed at their parents’ rate.

Contributions in a Roth IRA, however, will not be taxed again. With a Coverdell, earnings are tax-free so long as they’re used for qualified education expenses.

When comparing different custodial account providers, it’s also important to look for fees associated with opening or maintaining the account, as well as fees triggered by trades or purchasing securities.

Pros and cons of custodial accounts

Custodial accounts have a number of benefits and some drawbacks. And different types of accounts have different pros and cons depending on your goals.

Given that, let’s look at pros and cons specific to UGMA/UTMA accounts:

Pros of custodial accounts

• There are no contribution limits (although gift and transfer tax rules apply).

• Funds can be used for any reason, as long as it’s for the benefit of the minor.

• They’re relatively easy to establish and manage.

• They provide access to a wide range of assets.

• A portion of income earned in these accounts is taxed at the child’s tax rate.

Cons of custodial accounts

• Since assets in a custodial account technically belong to the child, it could affect financial aid eligibility.

• Unlike with a Coverdell ESA, the beneficiary cannot be changed.

• Contributions are not tax deductible.

• Funds in the account will belong to the young adults free and clear when they reach a certain age, which might spell trouble if they aren’t financially responsible.

• Contributions to UGMA/UTMA accounts are irrevocable.

A custodial Roth IRA has some great benefits—like its growth potential, as funds are only taxed before they’re deposited. There is also some flexibility in what your child can use the funds for (there are tax breaks for using a Roth IRA to buy a first-time home or use it for education expenses). However, contribution limits are relatively low and your child needs to be earning an income in order to open a custodial Roth IRA.

Is a custodial account right for you?

A custodial account can be a helpful financial planning tool that allows you to set money aside for your child’s future. If saving for college is your goal, the tax advantages of a Coverdell ESA are important to consider.

If you’re just looking to set aside money or other assets for your child, UTMAs or UGMAs can be good options to consider. Another option some parents consider are trusts, which can provide more control over what your children can do with the money when they become adults — and when they’ll receive it. A Northwestern Mutual financial advisor can help you weigh your options and show you how each fits into your larger financial plan.

This publication is provided for informational purposes only and should not be interpreted as financial, tax, or legal advice. Northwestern Mutual and its representatives do not render tax advice. Consult with a tax professional for tax advice that is specific to your situation. All investments carry some level of risk, including the potential loss of principal invested.