Custodial account: Give a Child in Your Life a Financial Boost
“Save and invest money in my nephew? Why would I do that?”
Why? To give him a gift that lasts far beyond his current age and interests. To prepare him for the future.
If you told someone you wanted to invest in your niece, nephew’s or grandchild’s future, what would they say? Some might be impressed by the idea. Others might think it an odd or unachievable ambition.
But what about you? What are you willing to do for your loved ones? Financially speaking, that is. For now, there’s no need to get into the moral or emotional side of things. It’s all about practicality. And about teaching financial literacy and helping someone you care about achieve financial independence.
A few years ago, the Survey of Consumer Finances conducted a study that found only 2% of young Americans are the recipient of a trust fund. The median amount of a trust fund was said to be around $285,000 with the average just above $4M.
(Note: a trust fund is not the same thing as an inheritance.)
Although the details of that survey are unclear, the results would seem to indicate that the majority of trust fund givers are those with high incomes. And probably good financial sense and investment knowledge. Some may even be beneficiaries themselves of generational wealth.
Whatever the case may be, there are some issues with this phenomenon. One of these issues, of course, is that those who perhaps could benefit from a trust fund don’t get one.
On the one hand, it makes sense that lower-income families or those without a financially stable background would have difficulty setting aside money for the next generation. Few people have enough money for their own retirement, let alone hundreds of thousands of dollars for someone else.
But you don’t have to be rich to create a nest egg for a loved one. You don’t even have to be lucky.
All you need is a little financial planning and a good understanding of personal finance, especially when it comes to investing, budgeting and saving.
How to Invest in a Loved One’s Future
Not just your child – you can invest in any child’s future. And the best part is:
You don’t have to be their parent.
You don’t have to wait until they’re born.
You don’t even have to have a ton of money.
There are a few ways to do this. If you’ve ever heard of a “nest egg” or the concept of an investment account, chances are you already have an idea of how to get started. But if not, here are the top ways you can start investing in a loved one’s financial success now:
Custodial account (UGMA or UTMA)
Custodial IRA
529 plan
Custodial Accounts
A custodial account is an account set up by an adult for a minor (aka the beneficiary) through a financial institution. The adult can be directly related to the minor, such as in the case of a parent or legal guardian, but they don’t have to be.
The adult acts as custodian of the account and controls it until the beneficiary reaches the age of majority (18 or 21 years old, depending on the state of residence). At that point, the custodian transfers controllership to the beneficiary.
While the beneficiary is still a minor, any adult can contribute to the account, including the custodian, other family members and friends of the family. Contributions are generally unlimited and have minimal to no withdrawal penalties.
However, contributions are irrevocable. This means, once a contribution has been made to the account, nobody can withdraw it unless it is for the clear benefit of the child.
Depending on the type of account, different rules apply, including:
Tax limitations and exemptions
Types of assets that can be contributed
Minimum balance in the account
Interest rates
There are two main types of custodial account: UGMA (Uniform Gift to Minors Act) and UTMA (Uniform Transfers to Minors Act) accounts.
Although similar in many ways, UGMAs and UTMAs differ in terms of the financial assets they can hold.
UGMA: Contributions are limited to cash, annuities, securities (mutual funds, stocks and bonds) and insurance policies.
UTMA: These accounts can hold the same types of assets as a UGMA. But they can also hold real estate, items with monetary value and intellectual property.
Custodial accounts are generally easier to set up and maintain than trust funds. They also have certain tax advantages due to being in a minor’s name.
Some disadvantages of custodial accounts include:
Irrevocable contributions
Assets could be counted against a child when seeking financial aid for college
Fewer tax advantages than other accounts
Custodial IRA
Similar to the UGMA and UTMA accounts, a Custodial IRA is a great way to invest in a child’s future. Custodial IRAs work a little differently from normal custodial accounts, however. A few things to note before opening a Custodial IRA:
The child (beneficiary) whose name is on the account must have an earned income of some kind.
Custodial IRAs offer certain tax benefits to the beneficiary.
The account may come with certain administrative fees, depending on the financial institute.
As long as the child earns income – whether it’s from mowing the neighbor’s lawn, babysitting or working as a waitress/waiter –, you can open a Custodial IRA for them.
529 Plan
A 529 Plan is a savings account geared towards the child’s education. Most 529 Plans are established to build a fund for a child’s college expenses, but others are meant to cover primary and secondary education.
The main benefit of opening a 529 Plan is that it is a tax-advantaged account. This means the assets in the account grow tax-deferred and that withdrawals up to $10,000 are not taxed.
There are two main types of 529 Plan: prepaid tuition plans and savings plans.
Prepaid tuition plans: The owner of the account selects a specific college or university and prepays the tuition at current or today’s rates, thus locking in the tuition cost.
Savings plans: These act similarly to prepaid tuition plans, except the money can be used for any qualified higher education costs. This includes tuition, room, board, books, supplies and college administration fees.
Unlike UGMAs and UTMAs, 529 Plans do have a contribution limit. This limit varies by state and can range from a couple hundred thousand to over half a million dollars.
What about a Trust Fund?
Trust funds are another great way to help prepare your loved one financially. They can be used in many different ways and offer a sense of financial security early on.
However, they are a bit more complicated to set up than a custodial account. Because of this, if you’re considering establishing a trust fund, you may need to consult an attorney to help you with it.
On the flipside, trust funds usually provide more control and flexibility to the owner than custodial accounts. Whereas a custodial account has certain limitations and technically belongs to the minor (or will once they reach the legal age), a trust fund belongs to the one who sets it up.
Some of the things a trust fund allows you to do include:
Establish specific limitations on when and how the money/assets in the fund can be used.
Requirements the beneficiary must meet before gaining access to the fund (ex. full-time employment, college graduate, traveled abroad, etc.).
As with other accounts made for children, a trust fund can be created by a legal adult, family or otherwise.
There are two main types of trust fund: living trust and revocable trust.
Revocable trust: Also called a living trust, the revocable trust can be modified or adapted over time as the owner sees fit. A revocable trust can also be used to reduce estate taxes and secure the privacy of the owner and any beneficiaries. Revocable trusts do require more paperwork and can be complicated to maintain or change though.
Irrevocable trust: Unlike revocable trusts, irrevocable trusts are nearly impossible to change once established. Usually, to make modifications in an irrevocable trust, you need to get permission from the beneficiary or beneficiaries first.
Reasons to Invest in a Child’s Financial Future
There are so many reasons to invest in a loved one’s future, including:
Further education
First apartment
First car
Down payment on a house
Travel
Gap year before or after college
Wedding fund
(Very) early family planning
Cost of living and inflation
Early retirement planning
Not only can you help set them up for success, but the account you create now can be used at any point down the line (unless specified otherwise in the account’s terms).
In other words, just because the beneficiary reaches the age of majority, that doesn’t mean they have to withdraw the funds or assets immediately. Instead, they can let the account continue to grow and even make their own contributions to it over time.
Besides that, a custodial account, trust fund or other account is a great opportunity to teach your loved one about financial literacy. From saving to budgeting to money management and planning, even a child can benefit from gaining a bit of financial literacy. If anything, they may benefit even more by learning how to manage and understand money early on in life.
Source: NMRA
Why Not Just Give Cash?
Cash is a great gift, especially one given by distant relatives or family friends at birthdays and other holidays. But it doesn’t have nearly the same benefits as a custodial account or trust fund.
According to the IRS, cash gifts up to $15,000 annually don’t have to be reported on one’s taxes. Cash gifts made for medical or educational purposes may also be excluded from taxation if they’re given directly to the academic institution or healthcare provider. This tax exemption may depend on the state and other reasons for the gift.
However, things like stocks, bonds, property and cash may be subject to tax if they exceed $15,000 ($10,000 in some states).
In a custodial account, the first $1,050 is tax-free. The next $1,050 is taxed at the child’s lower tax rate. After that, any earnings are taxed at the adult’s rate.
Besides certain tax advantages, a savings and/or investment account for a child could gain compound interest. In short, compound interest is the interest earned on the original balance and on the interest. Cash, even if it’s set aside in a savings account, usually gains a much smaller amount of interest.
Here’s an example of an account building compound interest over time:
In other words…
Initial starting amount is $1,000 with 5% interest, compounded annually.
Additional yearly contributions = $1,200
Total contributions over 18 years = Around $22,600
Total interest gained over 18 years = Around $14,473
Final balance of the account = Approximately $37,000
Of course, the compound interest will depend on the type of investment and account, as well as whether or not it’s a high-yield savings account. These are all factors you can consider or discuss with a financial advisor when determining which type of account is best for you.
And if that’s all too complicated, here’s the key takeaway:
The sooner you start investing in your loved one’s future, the more wealth you’ll be able to build for them. By putting money into an investment account rather than a traditional savings account, you’re more likely to see a much greater return on your investment.