A custodial account is a financial account set up by an adult on behalf of a child. Custodial accounts are frequently set up by parents as a simple way to transfer money to their children. Parents will do this for a variety of reasons, including:
- To get their children interested in investing early for the benefits of long-term compounding.
- To transfer a nest egg to their children while the parents are still alive.
- To lower the household's taxes, as the first $2,000 in investment income in a custodial account receives a tax benefit vs. if the parent received that investment income.
- The fact that a custodial account is really easy to set up -- making it a fairly low-cost way to get money transferred to your children.
Despite those benefits, there are several reasons to be wary of custodial accounts.
What can go wrong in a custodial account?
One of the key risks with a custodial account is the fact that once funded, the money becomes irrevocably the property of the child. You can't change your mind and take it back. Additionally, if the money gets spent, if must be for the benefit of that child. If you spend it or authorize it to be spent while you're the custodian, it must be for the benefit of the child.
On a related note, once that child reaches the age of majority -- typically 18 or 21 in most states -- that child gets complete control over the money in that account. While some young adults may be incredibly responsible, others won't be. Unless you have a working crystal ball, you won't be able to tell for certain at the time you fund the account that your child will be able to handle that money responsibly once he or she gets control of it. But in a custodial account, that's the chance you take.
Additionally, even if your child is completely responsible, he or she may not be able to let that money compound for decades because of the way assets are treated in college financial aid decisions. Money in a custodial account is treated as a child's asset when it comes to those college financial aid calculations. The general rule is that 20% of a dependent student's assets are considered available for college funding, vs. 5.64% of a parent's assets.
As a result, if there's a chance your child will need financial aid to pay for college, the net result of that calculation could leave the family worse off than had the money stayed in the parents' accounts.
What are the alternatives?
Still -- as a parent, you want to take care of your children and help them get a great start on life. If part of your plan to do that involves funding on their behalf, you have alternatives to a custodial account. Many of those alternatives give you better opportunity to control when, where, and how your child accesses the money, addressing some of the key risks of custodial accounts.
For instance, if you want to help pay for your child's college, a 529 account might be a better choice. Unlike a custodial account, a 529 account is considered the parent's asset when it comes to federal financial aid applications. Additionally, should your child get a scholarship, you can withdraw money up to the amount of the scholarship from the 529 account without paying the 10% penalty normally associated with non-qualified withdrawals.
And should your child elect not to attend college, the money can be redeployed to your own or another child's education, while a custodial account remains that child's property. If you have no other children or plans to continue your own education, you can still withdraw the money. You'd pay taxes and a 10% penalty on the money above and beyond your initial contributions, but whatever remains would be yours to use as you see fit.
If your goal is to help your child with longer-term wealth creation, you might want to consider helping them fund their IRAs, as long as they're earning money. Your child needs sufficient taxable compensation to cover the amount of the total contribution to his or her account, but it doesn't matter if the check that actually funds the account comes from your pocketbook or your child's.
If you have other goals for helping your child -- such as a gift down payment for a house -- you can keep money in your name with the mental note attached that it's earmarked for that gift. When it comes time to actually cover the related expense, you can hand over the money then. Depending on the amount involved, it might require a gift tax filing that would start eating into your lifetime exemption, but unless your estate value runs above $5 million or so, it wouldn't trigger any incremental taxes.
Helping your kids remains a worthwhile goal
Whether it's via a custodial account or some other method, helping your kids financially can be a worthwhile goal. Just be sure to understand the limitations of whatever funding mechanism you choose to use, and it will help improve your chances that the money will help your child in the way you hoped.
Chuck Saletta has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.