As the global economy evolves, countless investment opportunities are embedded in financial markets. If you want to profit from these opportunities, opening a brokerage account is an essential step. Through a brokerage account, you can buy and sell various assets such as stocks, forex, and more to achieve your financial goals. For adults, owning a brokerage account in their own name is the simplest solution. However, if you want your child to see the possibilities of the investment world early on and be in a leading position for long-term financial success, what should you do？

Most brokers and financial institutions do not allow minors to directly open accounts. Instead, opening a custodial brokerage account may be a good solution. Read this article, and you will comprehensively understand custodial accounts.

Definition of Custodial Brokerage Account

A Custodial Brokerage Account is an investment account opened and managed by a guardian on behalf of a minor. Typically, the guardian is responsible for overseeing the account until the minor reaches the legal age, which is usually 18 or 21. These accounts allow the guardian to make investment decisions in the best interest of the minor, including the purchase of securities such as stocks, bonds, mutual funds, and more. When the minor reaches the legal age, the guardian's control ends, and the account is typically transferred to the beneficiary's name, granting them complete control over the account and its assets. This type of account provides minors with the opportunity to participate in the financial markets and investments, even if they are not yet eligible to open their own brokerage accounts.

Types of Custodial Brokerage Accounts

Custodial brokerage accounts are typically classified according to legal regulations. In the United States, there are primarily two types:

Uniform Gift to Minors Act (UGMA) accounts

UGMA was enacted in 1956 and revised in 1966. The act provides a method for transferring financial assets to minors without the need for the time-consuming and costly establishment of a formal trust. It allows assets or other properties to be managed by a custodian appointed by the donor and is exempt from gift tax within certain limits. These assets are limited to financial instruments such as cash, stocks, bonds, and insurance products (policies, annuities).

Uniform Transfers to Minors Act (UTMA) accounts

UTMA was finalized by the National Conference of Commissioners on Uniform State Laws in 1986 and has been adopted by the majority of states. Its basic functionality is similar to UGMA, providing a convenient way for minors to save and invest without incurring tax burdens. UTMA is an extension of UGMA. In addition to the financial assets allowed by UGMA, custodial accounts established under UTMA can include any type of tangible or intangible asset, including real estate, artwork, and intellectual property.

In most cases, you may not have a choice between UTMA and UGMA. Your residency state will determine which legal framework you can use when establishing a custodial account. Even if you later move to a different jurisdiction with different rules, most brokers may not be eager to have you restructure the custodial brokerage account to comply with the UTMA or UGMA rules of the new state.

How Custodial Brokerage Accounts Operate

Account Establishment

The guardian needs to select a brokerage firm or financial institution and fill out the relevant application forms to establish a custodial brokerage account. During the account setup, the guardian must provide personal information, identity documents for both the guardian and the child.

Selection of Investment Instruments

Once the account is established, the guardian can begin selecting investment instruments such as stocks, bonds, funds, etc., to build a diversified investment portfolio. The chosen instruments should comply with regulatory requirements and consider the child's investment goals and risk tolerance.

Account Management

The guardian retains control and management rights over the account after its establishment. This includes executing buy and sell transactions, adjusting the investment portfolio, handling dividends, and interest. The guardian needs to stay informed about market trends to make informed investment decisions.

Account Purpose

Custodial Brokerage Accounts usually have specific purposes for the funds, such as covering educational expenses for the child. The guardian must ensure that the account's usage aligns with relevant regulations.

Consideration of Tax Implications

The guardian needs to be mindful of potential tax obligations arising from investment returns. Capital gains, dividends, and interest income may impact the guardian's tax situation, necessitating careful consideration and planning.

Recordkeeping and Reporting

The guardian is responsible for maintaining records of all account-related transactions and ensuring compliance with reporting obligations dictated by regulations. This includes regular account statements, tax filings, and other necessary documentation.

Transfer of Account Control

When the underage child reaches the legal age (typically 18 or 21), the guardian must transfer the control of the account to the child. This means the child will have complete autonomy over their investment account and the authority to make all decisions. It's important to note that this process is irrevocable.

Pros and Cons of Custodial Brokerage Account

Pros

Investing for Minor Children

Provides an opportunity to invest on behalf of minor children, helping establish reserves for their future expenses, education costs, etc. Managing an investment account together with children can also serve as an educational opportunity, aiding their understanding of investments, financial planning, and the market economy.

Tax Advantages

The IRS considers the minor children as the owners of the account, allowing the income within it to be taxed at the child's rate to some extent. Each child under 19 (or 24 if a full-time student) submitting as part of their parents' tax return can benefit from a certain amount of “unearned income” at a lower tax rate.

Significant Flexibility

There are no income or contribution restrictions, and no requirement for periodic distributions at any time. While the stipulation is limited to using the funds “for the benefit of the minor,” this requirement is vague and not restricted to educational expenses, similar to college savings plans. As long as the beneficiary derives benefit, the custodian can use the funds for various purposes, from providing housing to covering clothing expenses.

Cons

Loss of Control for Guardians

Once minor children reach the legal age, they gain complete control, and this process is irreversible, with guardians unable to intervene in the account. This may result in guardians losing control over the financial decisions of their children.

Adverse Impact on Financial Aid Applications

UGMA and UTMA accounts are considered assets of the minor. This can reduce a child's eligibility for financial aid when applying for college. It may also diminish their ability to qualify for other forms of government or community assistance.

Another Option: 529 Plan

In contrast, the 529 plan offers an alternative way to save for minors. The 529 plan is a tax-advantaged savings plan designed to assist with education expenses. Initially limited to higher education costs, it expanded in 2017 to cover K-12 education and further expanded in 2019 to include apprenticeship programs.

There are two main types of 529 plans: education savings plans and prepaid tuition plans.

Education Savings Plans: Contributions to these plans may be tax-deferred, and withdrawals are tax-free if used for qualified education expenses.

Prepaid Tuition Plans: Allow the account owner to pay current tuition for future attendance at specified colleges and universities. This means you may be able to lock in lower college entry costs.

Compared to UGMA and UTMA accounts, 529 plans allow parents to retain control over the funds. Additionally, these accounts are considered parental assets in the Free Application for Federal Student Aid (FAFSA), minimizing their impact on eligibility for financial aid.

However, the 529 plan is less flexible than UGMA and UTMA accounts. The plan requires you to use the funds for qualified education expenses, or else face penalties imposed by the Internal Revenue Service.

FAQs

Can I withdraw funds from the Custodial Brokerage Account？

Yes, you can withdraw funds from the Custodial Brokerage Account as long as the funds are used for the “benefit of the minor,” a vague term that includes, but is not limited to, educational expenses.

Can I establish separate Custodial Brokerage Accounts for multiple children？

Yes, you can establish separate Custodial Brokerage Accounts for each child. Each account is independently managed with its own investment portfolio and assets.

When can children take control of the Custodial Brokerage Account？

Children typically gain full control of the account when they reach the legal age, usually 18 or 21 years old. The guardian is responsible for managing and making decisions before this age.

What fees do I need to pay to manage the Custodial Brokerage Account？

Fees include transaction commissions, management fees, etc., and depend on the policies of the brokerage firm or financial institution. Guardians should understand and consider these fees.

Bottom Line

The time value of money is a crucial concept in investments, and no one has more time to realize their financial goals than children. The Custodial Brokerage Account provides guardians with a valuable channel to invest on behalf of their minor children, fostering financial growth for future endeavors like education expenses.

While offering tax advantages and significant flexibility in fund usage, it's essential to consider potential issues such as the loss of control when children reach the legal age and the potential impact on their eligibility for financial aid applications.