What do I need to know about custodial accounts?

You want the best for your kids. It’s kinda your job. Many would argue that includes providing a successful financial future for them, as well as instilling them with an understanding of and appreciation for investing.

If everything goes well, custodial investment accounts can help take care of both of those.

Some specific rules to know

Custodial accounts, like IRAs, are accounts held by a custodian for the benefit of someone else sometime down the road.

Unlike IRAs, these accounts are not tax-deferred. The account, while held with an adult as custodian, is in the child’s name, and registered under the child’s social security number. Therefore, any gains will be taxed at the child’s rate. Keep in mind that any sales with profits will be a taxable event.

Funds are generally made available to the kid at the age of maturity – in most states, that’s 18, though it varies by state and the institution holding the account.

Opening a custodial account is simple. Go to pretty much any brokerage with just a bit of information – the child’s social security number, birthdate, and the custodian’s employment information, and perhaps the child’s risk tolerance and objectives – and you’ll be on your way.

Downsides of custodial accounts

Of course, the big drawback of custodial accounts is the possibility of your child immediately blowing the account on clothes, video games, or a hot car. (My child used his money to get a pilot’s license – before he got his driver’s license! It was an excellent choice for him.)

Immature decisions can be avoided if you, the parent or grandparent, are active in modeling or teaching investing with your child. For example:

  • Do you plan to give your child some say in investment choices? There are plenty of companies around that are easy for a child to understand, that are worthy of investment dollars.
  • Do you plan to teach your child budgeting, giving, saving, and spending through an allowance?
  • Will you model and mentor with your own financial planning and investments?
  • Are you teaming with your spouse in making financial decisions? (This does not relate to your child, of course, but it you are doing this with your spouse, you’re more likely to do it with your child.)

If you don’t think you’re going to be able to be hands-on with your child in these ways, consider instead just creating a separate account in your own name that you can hand over once you feel the child is mature enough.

Alternatively, create a 529 or Coverdell educational savings account (which you control). With these alternatives, you can still give your child some say in managing, through simply saying, “This is money we’ve set aside for you, for when you start college or learn a trade. We want you to help us invest it…”

Bonus question: How should I invest my child’s account?

My suggestion is to think about the account as if the child were retiring at age 18 or 19 (when she would be starting college).

I’d suggest you should be oriented toward growth at birth, and getting more dividend-oriented, and more into cash as you get closer to college.

Remember that there will likely be a couple of recessions and stock market declines between birth and the start of college!

And while it’s nice to buy stocks that (hopefully) increase in value over time and make the most of your children’s long investing horizon, we’re fans of using these investments as teaching opportunities.

Because those are the roots of The Motley Fool.

When they were young, brothers David and Tom Gardner learned about stocks and the business world from their father at the supermarket. Dad, a lawyer and economist, would tell them, “See that pudding? We own the company that makes it! Every time someone buys that pudding, it’s good for our company. So go get some more!”

Decades later, that basic investment lesson taught to The Motley Fool’s co-founders has helped enrich hundreds of thousands of readers as part of the Fool’s mission to help the world invest better.

Click here for more from the Fool on investing for kids.

— Answer provided by Fool member Paul Thomas

 

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