When saving money for children, be sure to do so in a way that achieves your goals.
When considering ways to save money for minor children or grandchildren, using a custodial account is the first method that might come to mind. Here are a few tips to help you avoid common custodial account mistakes.
What is a custodial account?
A custodial account is generally created by a parent or grandparent for the benefit of a minor child or grandchild. When you put money into a custodial account, you make a gift to the minor beneficiary of the account, even though the minor does not control the account. The account creator usually acts as the account’s custodian.
The custodian of the account controls how money in it is invested and spent. The custodian must manage the account, can invest in most types of assets, and must use the funds in the beneficiary’s best interest until the beneficiary reaches the age of majority – age 18, 21 or even 25, depending on the state. Upon the beneficiary’s reaching the age of majority, the custodian has a duty to turn the account over to the beneficiary, at which time the beneficiary will become the account owner with complete authority over the account.
Funding an account – using the annual exclusion
Transfers to custodial accounts are gifts. Each parent can give each of his or her children $18,000 every year ($36,000 from a couple) without having to use any lifetime gift tax exemption—this amount is known as the annual exclusion. Similarly, grandparents can give the same amounts to each of their children and grandchildren every year.
You can make gifts to a child or grandchild above these limits, but doing so will use up a portion of your lifetime gift and estate tax exemption.
People typically don’t fund custodial accounts with amounts beyond the annual exclusion; rather, they often use trusts for more substantial gifts.
Gifts to custodial accounts need to be coordinated with other gifts you make that also qualify for the annual exclusion. The most common types of these gifts are contributions to 529 education savings plans and contributions to irrevocable life insurance trusts or other trusts that give beneficiaries a power to withdraw contributions.
If the donor of the account is also the custodian, the custodial account balance will be part of the donor’s estate if he or she dies while acting as custodian. While this is a risk for parents, it is even more of a risk for grandparents, so we recommend that grandparents refrain from acting as custodians of accounts they fund. Parents should take this risk into account when determining whether to act as custodians of accounts they fund for their children. Where grandparents create a custodial account and name the parents as custodians, the custodial assets may still be considered to be part of the parents’ estate, but will not be included in the grandparents’ estate.
Taxes and financial aid
Assets and income in a custodial account belong to the minor beneficiary (the child). Minors with unearned income such as interest, dividends, and capital gains, generally have to file an income tax return if, among other things, their unearned income is over $1,300 (in 2024). This includes income generated in a custodial account.
If the custodial account generates more than $1,300 in income and the minor files a return, there is no tax on the first $1,300 of that income. The next $1,300 of income is taxed at the child’s own tax rate. Anything over $2,600 is generally taxable at the child's parent's marginal tax rate. This is sometimes called the “Kiddie Tax”. If the minor also has earned income from a job, they are taxed at their individual rate on that earned income. The Kiddie Tax only applies to unearned income.
In addition, because custodial assets belong to the minor, they are counted as the minor’s assets for college financial aid purposes, even though the minor does not control the account and may not even know about it. When calculating financial aid, colleges will expect that 20% of a dependent child’s assets will be used to pay for college, which is a higher percentage than other assets, including parent-owned 529 accounts. See the J.P.MorganCollege Planning Essentials guidefor a more in-depth discussion about these topics.
Reaching the age of ownership
When a beneficiary reaches the age of majority (21 in most states), the custodian must turn the account over to him or her. At that time, the beneficiary will become the owner of the custodial account, controlling all of its assets. Many financial institutions will notify your child about the custodial account, and the need to convert it to a non-custodial account, shortly before they reach majority.
Frequently, the goal in setting up a custodial account is to provide funds to pay for college (see our Wealth Focus on Saving for Education for a broader discussion of college savings). If the funds are used to pay for college and related expenses, there may not be much money left in the account when your child reaches the age of majority, so this transition will not matter very much.
However, if college was paid for with other assets, or if the child attended a less expensive college than anticipated, or if the investments performed significantly better than expected, there may be a large amount of money left in the account when your child reaches majority.
Most parents and grandparents are not comfortable giving a 21-year-old complete control over what could be thousands or even hundreds of thousands of dollars. In many cases, turning over control is a significant worry to parents concerned that their children may end up having too much money all at once without enough experience to know how best to handle it.
If you have questions about custodial accounts or how to handle your child reaching majority, call to talk to a J.P.Morgan professional to discuss your options.
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