If you are a client who is saving and preparing for your (and your family’s) future, now might be a good time to consider setting up a custodial account. Here is a primer on the pros and cons of custodial accounts:
What is a custodial account?
A custodial account is like regular brokerage account in a minor’s name, controlled by the parent or guardian until they reach the age of 18 (or 21, depending on the state). A commonly known form of custodial account is a 529, which can be used for educational expenses. The 529 is an attractive savings option because it helps save for a minor’s educational expenses and can be transferred between beneficiaries. New in 2024, CNBC explains, money saved in a 529 plans that have been open for at least 15 years can be converted into a Roth individual retirement account tax-free, up to a limit of $35,000.
If your minor child is working and earns taxable income, you should consider setting up a custodial account for them. One option is a custodial Roth IRA account. They can invest their earnings into it and can deposit a maximum of $6,500 annually in earnings. This is a great way to help them get started on retirement savings. Many parents who own their own businesses put their kids’ earnings into a custodial Roth.This account grows until the account holder is 59 ½ (transfers to your child upon the age of 18 or 21).
Bankrate explains, custodial Roth IRAs are funded with your children’s post-tax dollars. That is, income tax and other applicable taxes have already been taken out. That’s why when your child is ready to withdraw the money for retirement, they won’t pay income tax on it 
According to SmartAsset, one of the most common types of custodial accounts is a Coverdell Education Savings Account (ESA). Parents or guardians can use a Coverdell ESA to save up for a child’s education while enjoying some tax benefits. Two other custodial accounts are UTMA and UGMA accounts. These accounts typically have fewer restrictions than an ESA.
What are the advantages?
With a custodial account, you can invest just like a regular brokerage account in a minor’s name. When the minor is of legal age of adulthood, in the state they reside in, the account then moves to the minor who can spend the money as they see fit.
What should I know about custodial accounts?
Changes to tax laws have affected some types of custodial accounts, like the UTMA, which doesn't have as much value as it once did. As of 2018, if the account is growing, any unearned income above $2100 is taxed at a higher rate -- which is the tax rate that applies to trusts/estates. This can be a very high rate and can affect the value of this account. Your gains are taxed above $2,100.
Are they tax-free?
According to Fidelity, a portion (up to $1,250 in 2023) of any earnings from a custodial account may be exempt from federal income tax, and a portion (up to $1,250 in 2023) of any earnings in excess of the exempt amount may be taxed at the child's tax rate, which is generally lower than the parent's tax rate.
Custodial Roth IRAs offer retirement benefits that are tax-free and offer penalty-free withdrawals later in life.
How do they compare to a 529 account?
A custodial account weighs more than a 529 in terms of financial aid. 529s offer a better tax advantage, as earning accumulate tax-deferred and distributions are tax-free (if used to pay for higher education expenses). You can also change the account beneficiary on a 529, where you cannot do that with a UTMA.
Who should consider a custodial account?
Some situations are more suited to setting up a custodial account and can help financial planning easier. For example, if your child inherits money, you may want to set up an account to grow this investment.
Overall, the custodial Roth is getting more traction if your child is earning money as a way to grow their earned income.
529 makes sense, grows tax-deferred, money can be moved to a different beneficiary if not used for higher education. It can be moved to different children or even a grandchild.
What’s the next step?
If you want to open a custodial account, reach out to us and we can help you with deciding which is the option for you. We’ll need basic information for you and your child. like Social Security numbers, employment, annual income and banking details to set it up.
The next step is to talk to your child about the account, involve them in the savings process and let them have a say in how much they want to contribute and how frequently. Parents can add matching contributions to their child’s, as long as it doesn’t surpass the $6,500 a year limit.
As your financial advisor, we can help you determine your goals so we can recommend which type of account is best for you and your family.