Opening a custodial account for a child is a smart financial decision that can have many benefits. A custodial account is a type of investment account that allows parents or other adults to invest on behalf of a minor child, who is the beneficiary of the account. This type of account offers many advantages, including the ability to save for the child’s future, teach them about money and investing, and potentially earn tax benefits. In this age of increasing financial uncertainty, opening a custodial account for a child can provide a solid foundation for their financial future. There are also some nuances to be aware of such as potentially impacting future college financial aid and the kiddie tax. In the following paragraphs, we will explore the benefits of a custodial account for a child in more detail.
Custodial Accounts Can Build a Solid Financial Foundation Early
There are many benefits to a custodial account including that it enables a child to build a solid financial foundation early. Instead of family and friends always buying toys, a custodial account enables them to gift money that can be used to buy stocks, ETFs, mutual funds and bonds. Over time this money compounds and can help a child have money to pay for large expenses as the enter adulthood like college, a first car, a first and last payment for their first apartment and more.
Custodial Accounts Teach Children about Money and Investing
A custodial account enables a child to learn about money and investing at an early age. They can be involved in investing decisions as appropriate such as using the money to buy shares in their favorite companies such as Disney. A child can also witness passive income at an early age by seeing their account get dividend payouts. They can also start learning about retirement tools at an early age like Roth IRAs.
Adult Retains Control of The Custodial Account
The account custodian, whether a parent or another adult, has control over the account until the child reaches a certain age. Depending on the state, the custodian will have control either until the child is 18 or 21. The custodian has control to make investment decisions, and can decide how much they want the child to be involved in the investment decisions.
Once the child becomes of age, the funds in the custodial account are legally theirs to control and use as they see fit.
Potential Tax Savings By Opening a Custodial Account
Though a child could end up owing taxes and/or being taxed at the parents’ rate if they make enough unearned income, a custodial account is still a potential way to save money on taxes. If a minor child exceeded the $2,300 annual limit in 2022, they would be taxed at the parents’ tax rate. However, the first $1,150 of unearned income is covered by the kiddie tax’s standard deduction. Therefore, a child would not pay taxes on this first amount. A child who makes $1,150- $2,300 in unearned income like dividends in 2022 will have to file a tax return and will be taxed at the child’s marginal tax rate. Only any amount above $2,300 will be taxed at the parents’ marginal tax rate.
What is the Kiddie Tax?
Before a custodial account is opened for a child, it’s important to become familiar with the kiddie tax. The kiddie tax is a law passed in the US to discourage wealthier individuals from transferring assets to their children to take advantage of their lower tax rates. Current rules tax a minor child’s unearned income like capital gains distributions, dividends and interest incomes at the parents; tax rate if their unearned income exceeds the annual limit. The annual limit in 2022 was $2,300.
The kiddie tax applies to dependent children under the age of 18 and full-time students younger than 24. Learn more about how children are taxed for their unearned income as well as how earned income can impact the taxes they pay see IRS Publication 929 and/or consult your tax advisor.
Custodial Accounts Have Potential Impacts to Financial Aid for College
Even though the custodian retains control of the account until the child is 18 or 21 depending on the state, colleges consider these accounts to be owned by the child. Since the custodial account is considered owned by the child, it could negatively impact the financial aid package from colleges.
Benefits of a Custodial Account for a Child Summary
In summary, there are many benefits of a custodial account for a child. Not only does it allow parents or other adults to save for the child’s future, but it also provides an opportunity to teach them about money management and investing. Additionally, a custodial account can potentially save money on taxes, which can help maximize the amount of money available for the child’s future needs. By starting early and making regular contributions, a custodial account can provide a solid foundation for a child’s financial future and help them build a healthy relationship with money. Overall, a custodial account is a valuable tool for any parent or guardian who wants to ensure their child’s financial well-being.