Secure Their Tomorrow: Understanding Custodial Accounts A Provident Financial Planning Comprehensive Guide

Written By:
Bavley Bebawi
Published On: 
October 23, 2023

Few endeavors are as rewarding and forward-thinking as preparing for the future of your loved ones. As parents, grandparents, or guardians, you are driven by a deep-seated desire to provide our children with every opportunity for success and security. But how do you safeguard their financial well-being and help nurture their dreams? The answer lies in thoughtful financial planning, and at the heart of this planning are custodial accounts—versatile tools that empower you to invest in your children's or grandchildren's futures while providing them with valuable lessons in monetary responsibility.

This Provident Financial Planning guide will explore the options for custodial accounts. We will discuss in depth the similarities, differences, and the common uses for each account. This guide will help you build a comprehensive awareness of custodial accounts and serve you in making the best decisions to secure your loved one's financial future.

Education is one of the most significant investments you can make in your child's future. It's no secret that education costs continue to rise, making planning essential. So, let’s begin this guide by discussing options to save for education.

Coverdell Education Savings Accounts:

Coverdell Education Savings Accounts (ESAs) were introduced in 1997 and established by Section 530 of the Internal Revenue Code. These accounts allow for tax-advantaged investments designed to encourage saving for educational expenses. These accounts can be used for primary, secondary, and higher education costs. Account custodians can make unlimited distributions from the fund annually to pay eligible expenses, including tuition and fees, books, supplies, tutoring, and computer/internet costs. ESAs also offer unique advantages compared to college savings plans, such as flexibility in choosing investments.

ESAs allow account holders to invest in various assets, such as individual stocks, individual bonds, mutual funds, exchange-traded funds (ETFs), and other investment vehicles. This flexibility means that account holders can generally earn a higher rate of return on their contributions over time, which can help the ESA grow in value.

As of 2023, the annual contribution limit is capped at $2,000 per beneficiary, no matter how many accounts are created by various grantors; this is a significant disadvantage because all grantors, including divorced parents and all grandparents, must coordinate their contributions to ensure the total contribution between all accounts doesn’t exceed $2,000 for each beneficiary. Excess contributions are subject to a 6% excise tax.

Not all individuals are eligible to contribute to ESAs. To be eligible to contribute to an ESA, single filers must have a modified adjusted gross income (MAGI) below $110,000, and joint filers must have a MAGI below $220,000. If you meet these contribution and income criteria, an ESA may be worth exploring.

Additionally, contributions to ESAs are considered an asset of the account custodian, typically the parent. ESA contributions must be distributed when the designated beneficiary reaches age 30 unless he or she is a special needs beneficiary. The custodian can change the account beneficiary to another member of the original beneficiary’s family under age 30. Moreover, the account ownership reported in the custodian's name must be listed on the Free Application for Federal Student Aid (FAFSA®). However, only 5.64% of a parent’s assets are available to pay for educational expenses compared to 20% of a student’s assets.  

Finally, contributions to an ESA are made with after-tax dollars, earnings in an ESA are tax-deferred, and withdrawals used for educational expenses, as discussed previously, are not subject to federal income tax. Distributions from ESAs that are not used for educational expenses are considered nonqualified. These expenses are subject to ordinary income tax on a pro-rata basis, considering the earnings and basis (contributions). An additional 10% penalty may apply to the earnings portion of a nonqualified distribution unless the beneficiary qualifies for an exception, such as death, disability, scholarship, or attendance at a U.S. military academy. Exceptions to the 10% penalty may also include the return of excess contributions if the distribution was made before June 1 of the following year.

Coverdell ESAs offer certain tax benefits and contain contribution/income limits worth noting. These tax benefits are similar to Roth IRAs for Minors and 529 Plans, which will be discussed in depth below.

529 Plans:

529 plans can also be an excellent option if you’re considering funding future educational expenses for your child or grandchild. Like ESAs, 529 plans are tax-advantaged savings accounts designed to help families save for future educational costs. However, a 529 plan has different tax advantages and contribution limits than an ESA.

Earnings in a 529 plan are federally tax-deferred, and distributions are entirely tax-free; however, 529 contributions may be tax deductible at the state level. To benefit from state income tax deductions on contributions or tax exemptions on withdrawals, you may invest in your own state’s 529 plan. Regarding contribution limits, you can typically contribute up to $17,000 per year if you’re single or up to $34,000 a year for couples without incurring gift taxes. 529 plans also allow you to “front-load” your contributions by making five years’ worth of the annual federal tax exclusion as an upfront lump sum. In 2023, that amount would be up to $85,000 per contributor per beneficiary. The IRS will treat this lump sum as if you deposited an annual $17,000 over five years. Unlike ESAs, there is no yearly income limitation on who can contribute to a 529 plan, and total contributions are generally limited to $300,000-$500,000, depending on the state in which you reside.

While it may seem like 529 plans are a more attractive choice, it is essential to note that ESAs offer distinct advantages over 529 plans, such as a broader range of qualified expenses and more investment flexibility. However, many people prefer 529 plans due to their higher contribution limits and lack of income limitations.

Roth IRAs for Minors:

So far, we have discussed accounts you can open for your loved ones, which are used explicitly for qualified educational expenses. What if you’d like to open an account that will fund your child’s future without the requirement of the earnings going strictly toward educational costs? A Roth IRA for minors may be a better option.

A Roth IRA for minors is a specialized individual retirement account for children under 18 with earned income. It operates similarly to a traditional Roth IRA but caters to young investors, allowing them to save and invest money for the long term while enjoying unique tax advantages. Roth IRAs offer diverse investment choices, including stocks, bonds, mutual funds, exchange-traded funds (ETFs), and more. The custodian and minor can choose investments that align with their long-term financial goals and risk tolerance.  

A minor cannot open a Roth IRA in his or her name, so a parent or legal guardian must function as the custodian on the minor’s behalf. The custodian manages the account, including making investment decisions, until the minor reaches the age of majority, as defined by state law. It's also important to designate beneficiaries for the Roth IRA. This designation determines who inherits the account upon the account holder's death. A minor can name a beneficiary once he or she takes control of the account.

There are essential eligibility requirements for opening this type of account. The child must have earned income, including wages, salaries, or self-employment income. Passive income, such as allowances or gifts, does not qualify. As custodian of the account, you may contribute the amount your child earned during the year from your sources of income. Contributions can also come from a combination of earned income and gifts from the custodian or other family members.

If your child earned $5,000 during the year, you or your child may contribute the $5,000 to his or her custodial Roth IRA. You can choose to fund the Custodial Roth IRA from your sources of income or your child's earned income, but how much to contribute is still dependent and limited to your child’s earned income that year. The 2023 contribution limit for custodial Roth IRAs is 100% of the child’s earned income or $6,500, whichever is less.

It is essential to remember that if a custodian were to contribute to the minor’s Roth IRA using his or her funds, these contributions may be considered gifts for federal tax purposes. Gift tax rules apply, but there is an annual gift tax exclusion limit ($17,000 in 2023), so contributions below this limit don’t typically trigger gift taxes.

Contributions made by the custodian to the minor’s Roth IRA are treated as if the child made them. The minor owns the funds; any qualified withdrawals, including earnings, can be tax-free. This setup enables tax-free growth on investments. Since contributions are made with after-tax dollars, any interest, dividends, or capital gains earned within the account remain exempt from federal taxation upon withdrawal, provided certain conditions are met. For a withdrawal to be considered qualified and not subject to federal income tax, the Roth IRA must have been open for at least five years, and the account holder, the minor, should at least be 59 ½ at the time of the withdrawal. Exceptions exist for specific purposes, such as using the funds for qualified educational expenses or a first-time home purchase. While Roth IRAs can be used for educational costs, they are not restricted solely to this purpose. Suppose the minor takes a withdrawal that doesn't meet the criteria for a qualified distribution (e.g. before age 59½ and the five-year rule hasn't been completed). Any earnings portion of the withdrawal may be subject to income taxes and a 10% early withdrawal penalty. However, contributions can be withdrawn at any time tax-free, as they have already been taxed.

Age is also essential to a Roth IRA for minors because starting early can significantly boost the account's growth potential. The longer the funds remain invested, the greater the potential for compounding returns. Additionally, Roth IRAs do not have age limits for contributions. Minors can continue contributing well into adulthood, even after reaching retirement age. The custodian retains control of the account until the minor reaches the age of majority (generally 18-21); at this point, the minor takes over management of the Roth IRA.

Opening a Roth IRA for a minor is an excellent way to educate a child or grandchild about financial responsibility, investing, and saving for the future. It can be a valuable learning experience for young individuals. Roth IRAs for minors can also serve as an alternative to 529 plans for education savings. While 529 plans offer specific tax advantages for education expenses, Roth IRAs provide more flexibility regarding how the funds can be used.

However, as noted above, a significant limitation of a Roth IRA for minors is that contributions to a Roth IRA depend on the child’s earned income and are generally capped at $6,500 per year. Other accounts do not have this limitation, which will be discussed below.

UGMA Accounts:

UGMA accounts, established under the Uniform Gift to Minors Act, have been popular for many years. These accounts provide a straightforward way to transfer assets to a minor while allowing the custodian to manage and invest those assets on their behalf until the minor reaches the age of majority, typically 18 to 21, depending on the state. UGMA accounts can hold many assets, including cash, stocks, bonds, mutual funds, real estate, etc. UGMA accounts (and UTMA accounts) are also not subject to annual income limitations. Taxpayers with higher adjusted gross income may participate in funding a UGMA or UTMA account.

When a custodian (or another individual) makes contributions to a UGMA account, those contributions become permanent property of the minor. A custodian cannot later reclaim or change the assets in the account. This irrevocable nature of UGMA accounts ensures that the assets are solely for the minor’s benefit.

Further, UGMA accounts don’t have specific contribution limits. Still, annual contributions to UGMA accounts are considered gifts, so these contributions are subject to federal gift tax rules. In 2023, the annual exclusion limit is $17,000 per recipient. This means you can give up to $17,000 to as many recipients as you like in a given tax year without paying gift taxes or reporting the gifts to the IRS. Of course, any gifts over $17,000 to a UGMA account (or UTMA account) will generally be subject to federal gift taxes.

While contributions to UGMA accounts are not tax deductible, the Kiddie Tax rule applies to dependent children under 18 at the end of the tax year or full-time students younger than 24, potentially subjecting their unearned income to their parent’s tax rate.  The Kiddie Tax rules are designed to prevent parents from shifting their investment income to their children to take advantage of lower tax rates that typically apply to minors. The first $1,250 of unearned income (such as interest and dividends) is generally tax-free, and the next $1,250 is taxed at the child’s lower tax rate as of 2023. Any income above this threshold of $2,500 is typically taxed at the parent’s rate.

UTMA Accounts:

Uniform Transfers to Minors Act (UTMA) and UGMA accounts share several similarities. Like UGMA accounts, UTMA accounts are custodial accounts designed to transfer various types of assets to a minor until the minor reaches the age of majority. Contributions made in both accounts are considered irrevocable gifts. If the minor reaches the age of majority, he or she gains control of the assets and can use them for purposes such as education, living expenses, etc. Both accounts are treated similarly treated concerning federal taxes. Investment income is generally taxed at the minor’s tax rate, contributions made to these accounts are usually subject to federal gift taxes, and the Kiddie Tax rules apply.

UGMA (and UTMA) accounts can also be incorporated into estate planning, particularly in the event of the donor’s incapacitation or passing. One of the primary advantages of using UGMA/UTMA accounts in estate planning is their ability to bypass probate, the legal process through which a deceased person’s estate is settled, debts are paid, and assets are distributed. Since the investments in UGMA and UTMA accounts are already legally owned by the minor, they are not considered part of the donor’s estate when the donor passes away. As a result, these assets are not subject to the probate process. Probate is primarily concerned with settling the estate and distributing assets that are part of the estate, not assets held directly by another individual.

UTMA accounts, although similar to UGMA accounts, have a few distinct differences. UTMA accounts allow for a more extensive range of assets than UGMA accounts, including real estate, artwork, and intellectual property. While UGMA accounts specify the age of majority (usually 18 or 21), UTMA accounts may allow you to select a higher age of up to 25 in some states. This extended control can be beneficial if you're concerned about your child's financial maturity.

In summary, UGMA and UTMA accounts are popular because they aren’t limited to educational expenses; withdrawals can be used for anything that could benefit the child, and there are no contribution or annual income limits. Coupling these reasons with the attractive tax treatment and the estate planning benefits, one can see why UGMA/UTMA accounts are highly attractive options for individuals.

Please refer to the table below for a condensed comparison of all the custodial accounts discussed in this guide.

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Written By:
Bavley Bebawi
Published On: 
October 23, 2023
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