Custodial Accounts for Kids: Understanding the Trade-offs of This Great Teaching Tool
Many parents rely on piggy banks and birthday cash to teach kids about money. But more are now turning to custodial accounts – a hands-on way for children to learn about saving and investing. While these accounts offer great learning opportunities, they also come with several trade-offs worth planning for.
What you gain by using custodial accounts
Custodial accounts are managed by a parent or grandparent until a child turns 18 or 21 (depending on the state). There are two primary types of accounts:
- UGMA (Uniform Gifts to Minors Act) - only basic assets are allowed, such as cash, stocks, bonds, mutual funds and ETFs
- UTMA (Uniform Transfers to Minors Act) - also allows other types of assets, such as real estate, art, and intellectual property
In addition to providing children a way to learn the basics of saving and investing, here are several other advantages of using custodial accounts:
- Simple and accessible.Easy to set up at most banks and brokerages.
- Potential tax benefits.A portion of your kids unearned income is taxed at the child's lower tax rate.
- No contribution limits. Custodial accounts don't cap how much you or your child can contribute to the account.
- Flexibility. The account's money can be used for anything that benefits your child, not just education.
While custodial accounts can be great for teaching kids about money, they do come with several trade-offs you'll need to consider.
- Trade-off #1 : The Kiddie Tax
Custodial accounts can trigger something called the kiddie tax. Here's how it works.
In 2025, the first $1,350 of your child's unearned income is tax-free. The next $1,350 is taxed at your child's tax rate (usually no more than 12%). Any unearned income above $2,700 ($1,350+ $1,350) is taxed at the parents' rate, which can be as high as 37%!
What to do instead: If your child has earned income, a Roth IRA for minors offers tax-free growth and avoids the kiddie tax entirely.
- Trade-off #2: Impact on Financial AidCustodial accounts are counted as a child's asset on the Free Application for Federal Student Aid (FAFSA). Student assets are assessed at a much higher rate (20%) than parent assets (5.64%). This means that $10,000 in a custodial account can reduce financial aid eligibility by $2,000 or more.
What to do instead: If you're saving for college, consider a 529 plan. The account owner retains control, the funds grow tax-free, and qualified withdrawals are tax-free as well. Plus, 529 plans are treated more favorably in financial aid calculations.
- Trade-off #3: Loss of Control Once the child comes of age, they can spend the money however they want. If your goal was to fund education but your 18-year-old wants to buy a motorcycle instead, you’re out of luck.
What to do instead: Spread your child's earned income around multiple types of accounts. Put some in a 529 plan or other education account. Contribute another amount to a traditional or Roth IRA in the child's name. And make a deposit into a custodial account that your child can (eventually) do whatever they want with.
Bottom Line
Custodial accounts still have their place, especially for general-purpose savings or teaching financial responsibility. But it’s important to understand the trade-offs and long-term implications.
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