Custodial Accounts 101
How Can I Invest for My Child?
Nest Egg Team
As a parent, you want to do everything you can to set your kids up for success. Investing money for them regularly early on can help you build up enough to give them a strong financial start as adults. Here are options for investing in your child’s future.
Custodial accounts work a lot like accounts you use to invest for yourself. You can choose to pick your own investments at a traditional brokerage or use precrafted diversified mixes, like those in Nest Egg's portfolios. Gift tax rules still apply to custodial accounts: You can’t give any child more than $15,000 per year ($30,000 with a spouse) before you incur a gift tax. All assets are held in your child’s name—irrevocably. This means once money goes into your child’s account, you can’t take it out and spend it on anything that doesn’t directly benefit them, which could include anything from clothes to tuition expenses. Because the assets are legally your child’s, that also means that they assume legal control as soon as they reach your state’s age of majority. Depending on where you live, that could be 18 or 21. (Some states may allow you to defer this transfer until even later. Check with a financial professional to determine if this situation applies to you.) While the thought of a young adult gaining control of a potentially large sum of money can be intimidating, custodial accounts are a motivation for talking with your children about saving (such as creating a budget) and spending to establish good money habits early on.
Who it’s best for
Parents who want to give their children money they can use for any kind of expense once they’re adults.
Traditional brokerage account
You can invest for your child through a traditional brokerage account. These accounts give you full flexibility and broad investment options: You can invest in stocks, bonds,mutual funds and exchange-traded funds (ETFs) or predesigned diversified mixes, such as a Nest Egg Account . Money can be used for any kind of purchase or expense. There’s no maximum to the amount of money you can invest, but you also don’t get any real tax benefits. All increases in your account value—such as through dividend payments (which are small regular bonuses some companies or funds give shareholders as a thank you) or when you sell shares to withdraw money—will be taxed. Investments that you’ve held for longer than a year may be taxed at a lower capital gains tax rate, though. Keep in mind that gift tax rules still apply whenever you transfer assets to your child. That means you’d only be able to gift $15,000 of the investments you’ve held for them each year before you’d be subject to a gift tax. Married couples can give up to $30,000 a year per recipient before incurring a gift tax.
Who it’s best for
Parents who value ultimate flexibility and control. You retain complete control and can decide when, if and how much you gift your children.
529 accounts let you invest for your child’s education—and that’s about it. While the definition of what counts as education has expanded to include colleges, universities, trade schools, private K-12 schools and $10,000 of student loans, it’s still not as flexible as the offerings of brokerage and custodial brokerage accounts, which can be used for any kind of expense. 529 accounts are also subject to the same gift tax as custodial accounts, though a special provision allows a person to gift five years of contributions at once, provided they don’t make additional contributions for the next five years. Not only does this let you contribute more without a penalty, but it also allows you to have more money invested for longer. And this gives your child’s college fund more time to grow (and benefit from the associated years of additional compounding). Unlike custodial brokerage accounts, parents retain control of 529 accounts and they can designate different beneficiaries, like siblings or even themselves, if funds go unused. 529 accounts generally offer more limited investment options than custodial accounts. Offerings are typically limited to a selection of target-date funds (a mutual fund created to automatically shift your portfolio mix as you age) or investment mixes. But they do provide certain tax benefits that custodial accounts don’t. As long as they’re used for educational expenses, 529 accounts offer tax-free growth (meaning your investment returns and growth aren’t taxed), and certain states may allow you to deduct contributions from your taxes.
Who it’s best for
Parents who plan on sending their children to college, trade school and/or private school.
Individual Retirement Account (IRA)
Though they’re traditionally thought of as an investment option for working adults, Individual Retirement Accounts (IRAs) are technically available to anyone with an earned income. That means a kid who has held a summer job or babysitting gig in the past year can open one, too. (Although a parent will have to open the account on behalf of the child.) While contributions are limited to the amount of money that child earned in a given year (up to the $6,000 limit), IRAs can provide decades of tax-advantaged growth for your children and position them to benefit from years of compounding. Take this example: If your child invested just $1,000 each year starting at 16, in 50 years they might have more than $500,000, assuming a 7.5 percent rate of return. To get there, they’d only have contributed $50,000 of their own dollars—a tenfold increase. Keep in mind that money held in an IRA for a child is subject to the same rules as money held for an adult. Withdrawals before retirement age may result in a 10 percent penalty and be taxed. While Roth IRAs allow for penalty-free withdrawals of your contributions, in general, IRAs are designed for building long-term wealth and may not offer the same immediate versatility as traditional and custodial brokerage accounts.
Who it’s best for
Parents who want to help set their children up for the long term and recognize that funds may not be as accessible in the short term.
So, what’s the best way for me to invest for my kids?
While any type of investment account will allow you to invest on your child’s behalf, which account type is best for you ultimately depends on your goals. A gift solely for their education, for instance, might be best kept in a 529 account. But if you value offering your child flexibility, you might look to custodial accounts. Be sure to talk with your financial advisor to determine which account type and benefits might be optimal for you and your family. And remember to continue investing for your own financial goals and retirement alongside planning for your child’s future.
Investing involves risk including loss of principal. This article contains the current opinions of the author, but not necessarily those of Nest Egg. Such opinions are subject to change without notice. This article has been distributed for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.