Custodial Brokerage Accounts 101

A brokerage account is a must-have if you want to be a great investor. With a brokerage account, you can buy and sell stocks along with a host of other investments that can help you reach your financial goals. The more time you have to invest, the more likely you are to achieve the growth in your portfolio that you're seeking to attain.

For most people, owning a brokerage account in their own name is the simplest solution available.

But what if you want to open an investment account for a child? Most brokers and financial institutions won't let minor children open accounts directly. If you want your children to have their own investments, opening custodial brokerage accounts can be a great solution that will open their eyes to the possibilities of the investing world and give them a head start on long-term financial success. However, custodial accounts also have some requirements you have to follow, along with some potential traps for the unwary.

What is a custodial account?

A custodial brokerage account is an account that a person sets up on behalf of a minor child.

Most commonly, custodial accounts are held by parents, but there's no limitation on who can act as the custodian of a custodial account. Grandparents, other family members, or even family friends or professionals have the capacity to open custodial accounts on behalf of a child.

The most important characteristic about a custodial account is that opening the account creates something called a "fiduciary relationship" between the custodian and the child.

In other words, once you open a custodial account, you no longer have unlimited control over the assets in that account. The money in the account legally becomes the property of the child. As such, you have to invest assets and spend money in the account in the best interests of the child named on the account.

Within the framework of that relationship, the custodian has full authority to manage the assets in the account. The financial institution where the account is held will accept investing instructions from the custodian, and typically, you'll be able to execute trades or conduct other business in exactly the same way you'd do it with your own account. There aren't any limitations on investments possible within a custodial account that are different from what applies to any brokerage account.

READ MORE: Best Brokerage Account for Beginners

UGMA or UTMA?

One thing you'll commonly see with custodial brokerage accounts is an alphabet soup of acronyms. Two of the most common in this area are UGMA and UTMA, which stand for Uniform Gift to Minors Act and Uniform Transfer to Minors Act, respectively. But what's the difference between custodial accounts set up under UGMA versus those established with UTMA?

For the most part, there's little practical difference between an UGMA account and an UTMA account. Technically, the Uniform Gift to Minors Act usually provides for only a limited set of possible gifts, including cash, stocks, bonds, mutual funds, insurance policies, and other securities. By contrast, the Uniform Transfer to Minors Act allows you to set up a custodial relationship with just about any type of asset. Most notably, real estate transactions are permitted under UTMA but not under UGMA.

Most of the time, you won't have a choice between UTMA and UGMA. Your state of residence will define which law is available to you in establishing a custodial account. Even if you later move to a different jurisdiction where different rules apply, most brokers won't be in a hurry to have you recast your custodial brokerage account to match up with the UTMA or UGMA rules in your new state.

What are the advantages of a custodial account?

One benefit of custodial brokerage accounts is that they allow you to continue to invest money on behalf of a child without you having to hold legal ownership of those assets. That is particularly valuable for income tax purposes, because unearned income in a custodial account typically gets taxed to the child rather than to the person managing the account. Because most children have little or no earned income, they're often in lower tax brackets than their parents or other relatives, and so having investment income taxed on their returns can lead to lower tax bills or even no tax liability at all.

In addition, custodial accounts give you maximum flexibility in using the money on the child's behalf. That stands in contrast to some other types of savings vehicles for children, such as 529 educational savings plans, which require you to spend account money on qualifying educational expenses or else pay a penalty to the IRS.

What disadvantages do custodial accounts have?

Despite their benefits, custodial accounts aren't perfect. One common problem is that when a child who has a custodial account goes to college, the assets in that account are treated as if they belong to the child. That can have a much larger negative impact on the amount of financial aid that the child receives than if the money were held in a parent's brokerage account or in a tax-favored vehicle like a 529 college savings plan.

But the biggest downside for many parents is the fact that custodial accounts require the custodian to turn over the account to the child at whatever age the state in question says is the legal age of majority. That's typically either 18 or 21, and parents aren't always confident that their young-adult children have the financial responsibility to handle the money in a custodial account wisely at that age.

To be perfectly clear, once the child reaches the age of majority for their custodial account, they are legally allowed to use the money for whatever they want.

A couple last things to consider

Finally, it's important to remember that establishing a custodial account involves making a gift. As such, you're potentially subject to gift tax unless one of the many exclusions to the tax applies. Annual exclusion gifts of up to $17,000 per year (as of 2023) can be made with no gift tax implications.

Even if you go above that amount, a lifetime exclusion amount prevents you from having to pay immediate tax on the gift. However, if you go over the annual exclusion amount, you might need to file a gift tax return in order to claim the lifetime exclusion.

Get an early start on investing

The time value of money is an important concept in investing, and no one has more time to reach their financial goals than children. By opening a custodial brokerage account in the name of a child, you can provide a huge leg up for that child's financial future. Putting all of your savings toward a child's future needs into a custodial account won't always make sense because of the shortcomings that custodial accounts have, especially losing control when the child reaches legal adult age. But as one of many tools in an overall family investing strategy, a custodial brokerage account can play a vital role.

Ready to open a custodial account for a child? See The Ascent's list of best custodial accounts.