Custodial Accounts: Investing For Your Children

July 25, 2022

Many parents see the value in starting their child off on the right foot financially but aren’t quite sure how. Custodial accounts are the solution! The number of times I’ve heard “if only I had gotten started that young” is countless. The time at the beginning of our investing lives is more valuable than the later years because of compounding interest. See, if Person A begins investing $10,000 every year at age 20 they will have a million dollars by age 47. However, if that person were to start at age 10, they would only have to invest $3,000 to reach a million by age 47. Those 10 years represent less than 30% of the time invested but a 70% decrease in the yearly contribution needed to reach their financial goals.

custodial accounts

Investing for your Children: The best 5 accounts

As a minor, your child has limited investment options when it comes to opening anything beyond savings accounts for kids. But as a guardian, there are different types of accounts you can use to invest on behalf of, and with, your child.

Investing for your child while they’re still young can help build an education fund and show them the power of compound interest, all while potentially reducing the need to take on college loans later on in life.

  1. Custodial Roth IRA

If your child has earned income from a part-time job, they may qualify for a custodial Roth IRA. As a custodial account, the parent that opens the account manages the assets until the child reaches 18 (21 in some states).

Contributions to a Roth individual retirement account grow tax-free, and your child can even use the contributions—but not the earnings—for major expenses that pop up, like a car or down payment for a house, once the account has been funded for a minimum of five years.

Your child can withdraw money from the account, including earnings, for qualified education expenses without having to pay early withdrawal penalties.

  1. 529 Education Savings Plans

If you are looking for a tool to invest for your child’s future college expenses, a 529 plan may be a good choice. There are no contribution limits, but you could run into the limit for the gift tax, and anyone is eligible to open and contribute to a 529.

There are two types of 529 plans: Prepaid tuition plans, where you buy college credits for the future at today’s prices, and education savings accounts where you build a balance and invest your money in the market.

For the purposes of this guide, the latter might be your best bet. These kinds of investment accounts can be used to pay for qualified education expenses, and you can choose from a range of mutual funds and exchange-traded fund (ETFs).

Withdrawals from 529’sare tax-free as long as they’re used for qualified education expenses. Depending on the state where you live, contributions may be tax deductible, or you may be eligible for a tax credit on your state income tax return.

  1. Coverdell Education Savings Accounts

Similar to 529 plans, Coverdell Education Savings Accounts are investment accounts for your child’s education. Contributions grow tax-free, and withdrawals are also tax-free when they’re used for qualifying education expenses, such as college tuition or books.

Unlike 529 plans, Coverdell accounts have strict contribution limits. The maximum you can contribute is $2,000 per year per beneficiary. Higher-income households—those with a modified adjusted gross income (MAGI) between $95,000 and $110,000 per year, or $190,000 to $220,0000 if you are married and file a joint return—have a reduced contribution limit. Those with incomes over those thresholds are not eligible to contribute to a Coverdell.

  1. UGMA/UTMA Trust Accounts

The Uniform Gift to Minors Act or s (UGMA/UTMA) are custodial trust accounts. A parent or guardian can open an account on behalf of a child, and they or an advisor act as the account custodian until the child comes of age. Depending on your state, the age the child takes over the account ranges from 18 to 25. The custodian can make contributions and invest that money into stocks, bonds or mutual funds to grow the account balance. Other family members can also make contributions to the account.

These UGMA/UTMA accounts have some benefits over a 529 plan due to the flexibility in use of funds. The funds can be used for things beyond education, but because of that, they do not have as many tax advantages. Withdrawals from these custodial accounts can be used to pay for a child’s education or anything else that benefits them. Once the child reaches the age of majority in their state, the account is under their control to use as they wish. The child can use the money to pay for college, purchase a car or to put toward a down payment on a home.

  1. Brokerage Account

Some brokers have accounts specifically designed for teens. According to Wendy Baum, a financial professional with Equitable Advisors, these can be excellent options for children. Standard brokerage accounts are great for children because they have minimal fees and provide for a buy-and-hold strategy for long-term investing, however, they lack tax advantages. In a brokerage account, stocks, bonds, mutual funds and ETFs can be purchased for a variety of investment options. Involving children in a few select stock picks is also a great way to get them interested in investing at an early age.

Unlike other options that require a parent or relative to act as the custodian, these accounts give ownership to the child. However, parents or the family’s advisor should always monitor a child’s account activity.

For example, Fidelity launched its Youth Account in 2021. The account is available to teens between the ages of 13 and 17, and teens can invest in most U.S. stocks, ETFs and Fidelity mutual funds. It also offers fractional shares, allowing teens with limited funds to invest right away. These accounts don’t offer the tax advantages of the other account options listed above, but they do give kids a sense of ownership and control—and the chance for parents and children to learn about investing together.

Advantages of Investing for Kids

According to a recent poll, only 55% of Americans own stocks. Many people don’t invest because they find the stock market to be too confusing and don’t know how to get started.

Opening an investment account provides you with a great way to educate your child about how the stock market works and how investing can benefit them. This is a powerful way to provide your kids with the foundation they need to build long-term wealth.

Give Money Time to Grow

The earlier you start, the more your child will benefit from compound growth. Even small contributions can add up over time.

Consider the examples of compound growth below. If you opened custodial accounts when your child was just 1, here’s how much you’d have if you made monthly contributions to an investment account:

Reduce the Need for Student Loans

College is only getting more expensive. According to Vanguard, the price of a public in-state university may increase from $22,690 today to over $52,000 in 2039—the year a 1-year-old in 2022 will likely enroll for their first year of college.

Investing money now for your child’s future will help pay for their education, reducing the need for student loans later on and establishing a solid financial foundation.

What Else to Keep in Mind When Investing for Kids

While investing for kids can be a smart decision, there are some things to keep in mind before opening an account.

Financial Aid

Depending on the type of custodial accounts you open and the account’s ownership, there can be implications for college financial aid when the student submits the Free Application for Federal Student Aid (FAFSA).

  • Custodial IRA. Money stashed in a custodial IRA isn’t reported as an asset on FAFSA. The only way it would affect financial aid is when the student takes withdrawals for their education. Distributions from an IRA are considered student income. However, the FAFSA uses your information from two years prior, so your child can take distributions in their junior year without affecting their eligibility for financial aid for the final two years of college.
  • 529 Plan. In general, 529 plans have a minimal effect on financial aid. A 529 owned by a dependent student or parent is reported as a parental asset on the FAFSA, which has a smaller impact than student assets.
  • Coverdell Account. With a student or parent-owned Coverdell account, up to 5.64% of the account’s value will be included on the student’s expected family contribution (EFC). However, if the Coverdell is owned by a grandparent or another relative, only withdrawals are considered for financial aid purposes, but the withdrawals count as student income. Student income is assessed up to 50%, so it can have a significant effect on their eligibility for need-based aid.
  • UGMA/UTMA. Assets in a UGMA/UTMA trust account can affect a student’s financial aid eligibility because they are considered student assets. Student assets are weighed more heavily than parental assets, impacting their eligibility for aid.
  • Brokerage Account. If a brokerage account is in a child’s name, it is a student asset for FAFSA. But if the brokerage account is in the parent’s name, it has a smaller impact on their financial aid eligibility.

Gift taxes

Depending on how much you contribute on behalf of your child, you could incur gift taxes.

“Both 529 plans and custodial accounts are subject to the gift tax, which means parents are subject to an additional tax if they contribute more than a certain amount,” says Hale. “For 2022, the amount is $16,000 per child. This tax keeps people from avoiding taxes by giving money to their children.”

It’s a good idea to consult with an advisor before setting up a custodial account for your child to discuss tax implications for your unique situation.

Your Own Finances

While investing for your kids is a great thing to do, make sure your own finances are in good shape first. If you aren’t contributing enough for retirement or don’t have an emergency fund, focus on those goals first before setting aside money for your children in custodial accounts.

Planning for Your Child’s Future

Investing for kids is a great way to teach them the basics of investing, establish a solid nest egg and limit the need for education debt. However, make sure you carefully consider the different account options and their impact on your tax bill and your child’s future financial aid applications. But overall, starting early is an essential step in preparing your child for their future.


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