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Starting your investments early can make a big difference. Even if your child is too young to understand financial concepts or make investment decisions, you can still set them up for success by beginning the investment process now. Many online brokers offer custodial accounts, which allow a parent to invest on behalf of their child. Once your child reaches the legal age of majority, the account and the accumulated funds become their property. Here’s a guide on how to get started with investing for your child’s future through a custodial brokerage account, and whether this strategy is the right choice for you.
What exactly is a custodial brokerage account?
There are several options for setting up investments for your child while they’re young. Common choices include the 529 education savings plan and custodial Roth IRAs, but one alternative you might consider is a custodial brokerage account.
Custodial accounts, often structured under the Uniform Gift to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA), operate similarly to standard taxable brokerage accounts. However, since these accounts are custodial in nature, children don't gain control over the account until they reach the age of majority in their state. In the meantime, the custodian, which can include parents and other family members, can contribute to and invest the funds into stocks, bonds, or mutual funds to increase the account’s value.
Prominent brokers like TD Ameritrade, Fidelity, Merrill Edge, and Vanguard provide custodial accounts. In addition to traditional banks, there are third-party applications that help parents set up and manage custodial investment accounts for their children. While these platforms offer convenience, there are certain caveats to be aware of, which we'll explore shortly. (By the way, according to Union Bank, 401(k) plans are technically custodial accounts because employers act as custodians for employees. Fun fact, right?)
The advantages and disadvantages of custodial brokerage accounts
A key reason for opening a UTMA account is to utilize the gift tax exclusion, enabling the growth of investments for your child. This structure also provides more control over how the funds are invested and later spent. However, compared to a Roth IRA or 529 plan, UTMA accounts offer fewer tax benefits.
Unlike 529 plans, custodial accounts are subject to the 'kiddie tax' on unearned income beyond a certain threshold. For 2023, any unearned income (investment earnings) over $2,500 is taxed at the parent’s tax rate. Moreover, once funds are placed into a custodial account, they cannot be withdrawn.
With a UTMA, once your child reaches a certain age, they can use the funds in their account for any purpose, whether it’s tuition fees or purchasing a vehicle. In contrast, a 529 plan mandates that the funds be used strictly for educational expenses. Therefore, if your sole aim is to invest for your child’s future education, a 529 plan might offer superior tax-deferred growth. However, if you plan to use this investment as a supplement to a 529, providing your child with greater flexibility in how the funds are eventually spent, a UTMA gives you more options.
It’s also important to consider that a UTMA could influence your child’s eligibility for financial aid later on. For more details, check out the information here.
How to establish a custodial brokerage account
Custodial accounts can be set up by parents, grandparents, or guardians at almost any brokerage or financial institution. These institutions determine the specific terms of the account, including the initial deposit, minimum balance requirements, interest rates, and fees for account management. In most cases, these terms are comparable to those of the institution’s regular accounts.
To open a UTMA, the required minimum balance typically falls between $500 and $2,000. Contributions to the custodial account can be made by anyone, though gift-tax regulations often limit annual contributions to $15,000 ($30,000 for married couples) per child.
Be cautious of expensive third-party applications.
A key point to remember when setting up a custodial account for your children: Avoid falling for unnecessary fees. You can start your custodial brokerage account through a service like UNest—and if you’re new to investing, opting for a pre-built portfolio could be a helpful starting point.
However, the service fees these apps charge may not justify the guidance they provide. For example, Investor Junkie explains exactly how much you’d pay UNest to manage your funds:
...if you stick with the minimum $25 monthly contribution, you would be contributing $300 to your child’s custodial account over the course of one year. But with the $2.99 monthly fee, that means you’re paying 11.96% for UNest to manage your investment.
Compared to commission-free trading at most major institutions, UNest charges an excessively high fee that only makes sense if you have a larger account balance. Before you assume you need an investment app, consider seeking advice from your main online broker.
