A custodial account is any type of financial account set up by one person for the benefit of another. But most often, it refers to one opened by an adult on behalf of a minor, which is why you often hear some of them described as UTMA accounts. Regulated under the Uniform Transfers to Minors Act, those are a simple way to give assets to a kid while keeping some control over them, and frequently spare the child any tax consequences. For example, a parent (the custodian) may set up a college fund for the benefit of their child (the beneficiary).

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Types of custodial accounts

There are a few different forms of custodial accounts, and one common example is a Coverdell Education Savings Account, which is used by parents and other adults to save for a child's education. In this case, the parent or other contributing adult is the custodian, and the child is the account's beneficiary.

Another form of a custodial account is, as mentioned above, a Uniform Gift to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA) account, which allows property to be transferred to a minor without a formal trust. The minor is the account's owner, but the assets in it are controlled by the custodian until the beneficiary reaches the age of majority in the state where the account was established (generally 18 or 21). The primary contributor to the account is often the custodian, but this doesn't necessarily have to be the case.

Pros and cons of custodial accounts

There are some notable tax benefits to custodial accounts, especially Coverdell ESAs. While contributions to a Coverdell aren't deductible, any investment earnings are tax-deferred, and withdrawals for qualifying education expenses are completely tax-free.

While not quite as tax-advantaged as education-specific accounts, UGMA/UTMA accounts have the benefit that the first $1,050 in unearned income (such as dividends or profits from the sale of an investment) is tax-free, and the next $1,050 is taxed at the child's income tax rate, which is generally lower than that of the custodian. Only unearned income greater than $2,100 can be taxable at the parent's tax rate.

However, there are a few drawbacks to custodial accounts to be aware of. First of all, once a UGMA/UTMA account is set up, it becomes an irrevocable gift, meaning that custodians can't take back the money if they change their mind later on. The custodian can make certain withdrawals for the minor's benefit -- such as to pay for school expenses -- but the assets in the account belong to the minor.

Because of this, it's also important to remember that the funds in a UGMA/UTMA account can be used for whatever the beneficiary wants once he or she reaches the age of majority. For example, if you set up a UTMA account for the purpose of your child's college education, he or she isn't legally obligated to use the money for that purpose.

Finally, keep in mind that assets in a custodial account can affect the beneficiary's ability to qualify for financial aid. When applying for financial aid, a child's assets are assessed at a 20% rate, as opposed to a top rate of 5.64% for parental assets.

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