Being a parent involves making decisions early on about what sort of future you dream about for your children and how you are going to help make that a reality. For some parents, this means starting their child in a sport as soon as they can walk in hopes of them being a star athlete. For others, education becomes rigorous early on in an effort to land a prestigious university degree.
Some (hopefully most) parents have hopes that their children will grow up to be financially secure. This can stem from the parents maybe having had financial struggles and wanting better for their children, or out of gratitude for the impact a financial investment made by a parent or grandparent had on their own life. Making a financial investment in your child's future, even at a young age, can be a great way to set them up for success.
With so many investment options out there, doing research to determine what is best for you and your child is important. Whether you are wanting to save for your child to attend college, just want to surprise them with a lump sum of money as they enter adulthood, or even want to think way down the road and start saving for retirement as they start their first part-time job, there are a plethora of different investment and savings options.
What are custodial accounts?
One of the main options to start saving for your child's future is called a custodial account. These accounts are designed so that the minor (who is designated to benefit from these funds eventually) isn't able to access the account until a certain age – usually 18 or 21 (this varies from state to state and is referred to as the age of majority).
While it is definitely possible to access the funds before then, the custodian is required to approve any and all transactions. The assets legally belong to the minor but the custodian is solely responsible for protecting the assets until the child is old enough to do so themselves. A custodian could be a parent, grandparent, other relative, or really just about any legal adult.
Opening UGMA and UTMA accounts
The Uniform Transfer to Minors Act (UTMA) and Uniform Gift to Minors Act (UGMA) are what make it possible to open a custodial account at financial institutions. UGMA and UTMA accounts can be opened as essentially a typical savings account, but one the minor doesn't have access to without custodian approval, at your bank or credit union. If you're wanting to use the custodial account to make actual investments for the minor's future benefit, UGMA and UTMA accounts can also be opened at brokerages and mutual fund companies.
It's possible to open a custodial account without ever setting foot in a brick and mortar financial institution. Apps such as Stash allow for automatic investing for free the first month, then with a low monthly fee of just $1 after. They'll even give you $5 to invest just for signing up! If you have multiple kids, the monthly fee drops to $1 every 2 months for additional custodial accounts.
Stockpile is another great app that allows you to open a custodial account virtually. It's free to sign up, and while it does cost $0.99 per trade, there is no monthly fee for using Stockpile. Another bonus: you'll get $5 just for signing up!
While the minor technically owns the stocks purchased, the custodian is still the one responsible for all transactions and account activity. Stockpile actually encourages this in that the minor is able to initiate trades, but they must get approval from the custodian in order to be completed. When the minor reaches the legal age to take over access to the funds, Stockpile can help the minor transfer the assets into their very own account.
Opening a custodial account is just as easy as opening your own traditional financial account. After deciding where you'd like to open the account, you'll go through typical procedures to open an account with that company and will provide information for both yourself, as the custodian, and the minor. Be sure to also ask about filling out paperwork to assign a successor custodian should something ever happen to you. The apps mentioned above also make is super easy to open custodial accounts and provide clear instructions on their sites.
UGMA and UTMA account rules
While opening a custodial account might be just like any other average bank or investment account, UGMA and UTMA accounts have their own sets of rules. Legally, all funds in a custodial account must be used for the benefit of the minor. Custodial account withdrawal rules dictate that custodians are forbidden from using the funds for anything other than to directly benefit the child.
Since assets legally belong to the minor once they are deposited to the UGMA or UTMA account, or as income generated from investments, the custodian is not able to take funds back at any point. As a custodian, it would be a good practice to keep careful record of exactly how any assets withdrawn are used in order to prove it benefited the minor should there ever be a question.
Custodial account taxes can be one of the more attractive characteristics of the account – if the account remains under $2,000. As all assets in the account legally belong to the minor, the first $1,050 isn't taxed and the next $1,050 is taxed at the minor's rate. Anything beyond that, however, will be taxed according to the parent's rate.
Pros and cons of custodial accounts
While custodial accounts can be a great way to invest or save money for your minor at a lower tax rate, there are some disadvantages to UGMA and UTMA accounts. First, all assets are legally accessible to the benefitting minor the minute they reach the age of majority. Custodians aren't able to take back any funds and must be able to prove that all funds are withdrawn to benefit the minor, so there's no “shuffling funds” right before the minor's birthday if the custodian doesn't feel the child is responsible enough to have legal access to a lump sum of money.
Another downfall of a custodial account can be its effect on your child's ability to get financial aid for college. When applying for financial aid, assets that belong to the student weigh heavier than the parents' assets in determining how much aid will be awarded. As all custodial account assets belong to the minor, this can lead to a reduction in how much financial aid the minor is able to receive for college.
Alternative options to invest for kids
If your main goal in saving for your child's future is to pay for college, a custodial account might not be the best option. Instead, consider a 529 account as an alternative. With a 529 account, the account owner (often a parent or legal guardian, or potentially a grandparent) remains in control of the account even after the minor is legally an adult, unlike a custodial account in which control automatically transfers when the minor reaches the age of majority.
Additionally, 529 funds must be used to pay for college (or college-related spending). A custodial account has no stipulations on what the funds are used for, as long as it's for the benefit of the minor. As long as the funds in a 529 account are used appropriately, they aren't taxed upon withdrawal – a huge benefit of this account.
Another alternative to custodial accounts is a Roth IRA. Similar to a custodial account, the Roth IRA is opened in the name of the minor but is controlled by an adult until the child legally becomes an adult themselves, after which they take control of the account.
One downfall to opening a Roth IRA for your child is that the child must be old enough to earn their own money as contributions can only be made if the minor made money during the tax year. As long as the child is making money, contributions can be made up to as much as the child earned (or up to the Roth IRA annual limit, which is currently $5,500).
The adult in charge of the custodial Roth account makes investment decisions until the minor is old enough to take control of the account, and a huge benefit is that Roth IRA funds aren't taxed when withdrawn after 5 years. There is, however, an early withdrawal penalty for taking funds out of a Roth IRA before age 59 ½. This is waived, however, when the funds are used for specific higher education expenses, and funds in a Roth IRA don't factor into financial aid decisions. Both of these reasons make Roth IRAs a worthwhile college savings option. Additionally, up to $10,000 (as of 2018) can be withdrawn from a Roth IRA tax-free if directed toward the purchase of a first house. And finally, the fund can establish an amazing foundation for retirement – it's never too early to start.
Custodial accounts can be a great way to teach your child about managing money starting at a young age – without the risk of the child spending all the funds early and frivolously. A great way to encourage saving can be to match the funds your child saves or invests. Involving the benefiting minor in making appropriate decisions about investments can be a great learning experience as the child reaches teen years and gets closer to making their own financial investment decisions.
While there are clear benefits and downfalls to custodial accounts, UGMA and UTMA accounts are definitely options to seriously consider when looking for a way to start investing in a minor's future.
What money advice would you give to an 18 year old to help them live a successful, comfortable, and enjoyable life?