Once you understand the basics of custodial accounts, it’s important to know when UTMA and UGMA accounts are appropriate to use as well as be aware of common alternatives. Understanding the pros and cons of custodial accounts is a great place to start.
Pros of a Custodial Account
There are some great advantages to using a custodial account. Here are a few of them:
- No income limitations
- Withdrawals may be used for virtually any purpose without penalty
- No contribution limitations
- Many investment options
- The first $950 or so of income may be tax free. The next $950 or so of income may be taxed at the minor’s federal tax rate, which is usually relatively low.
Cons of a Custodial Account
Before opening a custodial account, make sure you fully understand the drawbacks of a UGMA or UTMA account. Here are some of them:
- Earnings above $1,900 or so may be taxed at the parent or custodian’s federal tax rate, which is oftentimes higher than the child’s tax rate.
- Transfers of money to a custodial account are irrevocable and cannot be taken back or used to benefit the grantor or custodian when a child misbehaves or when money is tight and a mortgage payment is due.
- Lack of control. The money is owned by the child. Once the child reaches the age of majority, he or she can use the funds for anything.
- Custodial account assets are generally considered to be the child’s asset for financial aid purposes, which may decrease college financial aid more than assets belonging to parents
- Custodial account assets cannot be transferred to another beneficiary
- Lack of tax benefits
- A custodial account can only benefit one minor. You would have to set up multiple custodial accounts to benefit multiple children or other minors.
- It may be difficult to transfer equal amounts of money to all children if the accounts are set up on different dates and contain different investments. You cannot make equalizing transfers between custodial accounts.
- An 18 or 21 year old may not be mature enough to manage large amounts of money.
When to Use a Custodial Account
As a general rule, a custodial account may be most appropriate for transfers of small sums of money that may not be worth the expense or hassle of setting up a trust.
UTMA and UGMA accounts may not be appropriate for huge transfers of wealth, assets that you may need or want back in the future, or assets that you definitely want to be used for a specific purpose (i.e. to be used for college tuition, etc).
Although custodial accounts do have their advantages and may be ideal in certain circumstances, more often than not, I see people opt for an alternative to a custodial account.
Custodial Account Alternatives
There are a number of alternatives to a custodial account, including trusts, 529 plans, and IRAs. I commonly see people choose one or more of these alternatives over custodial accounts for the following reasons:
- Tax benefits
- Asset protection
- Considered asset of the parent
- Ability to transfer assets to another child
Custodial Account or Alternative?
Personally I think most people are able capable of deciding for themselves whether a custodial account is appropriate for them or whether one of the alternatives listed above would be a better fit. Think about what your needs and goals are, and then see which option is a better fit for your unique situation, taking into consideration the pros and cons of each option.
If you are still unsure, you can always check with a financial advisor.
What are your thoughts about using a custodial account versus a trust, 529 plan, or IRA? Which of these options do you personally use and why? Leave a comment below!