Advantages of Custodial Accounts
By Kaye A. Thomas
Current as of July 8, 2016
A summary of reasons you might want to use a custodial account.
This page explains the advantages of using custodial accounts under the Uniform Transfers to Minors Act (UTMA). For an overview of these accounts, see Custodial Accounts 101. For important information on pitfalls you may run into using these accounts, see Problems with Custodial Accounts.
The highest and best use of custodial accounts is in situations where you have a genuine desire to make a financial gift to a child. In other words, they make the most sense when you aren’t focused mainly on the potential tax benefits described below. Perhaps you want your child or niece or nephew to have a taste of ownership in stocks, or simply to see the benefit of watching savings grow from compound interest. If the dollar amount is relatively modest, a custodial account may be the best vehicle for that type of gift.
Gift and estate tax
If you die holding a large enough estate, a share of what you would like to leave to your beneficiaries may go to the government in the form of estate tax. One way to avoid that result is to give away assets during your lifetime — but then you have to worry about gift tax. A common approach to this problem is to make annual gifts in amounts too small to be subject to the gift tax. The annual gift tax exclusion is adjusted each year for inflation; as of 2016 the amount is $14,000.
Such gifts are often made through the use of trusts, especially if the gifts are being made to minors. A custodial account can be used in place of a trust. For example, if you and your spouse each transfer $10,000 per year to a custodial account over a period of 15 years, at the end of that time you will have transferred $300,000, not counting all the earnings that accrued over that period of time, all without paying any gift tax.
There are serious problems with this approach, however. I strongly recommend against using custodial accounts for transfers of this magnitude. The added cost of setting up a trust for this purpose is well worth the money. For reasons, see Problems with Custodial Accounts.
Reducing income tax
The income of a custodial account is taxed to the child. Sometimes this is an advantage, if the child pays tax at a lower rate than the parent. However, the so-called kiddie tax, which can now apply up to age 24, usually eliminates most of the benefit from shifting income to children. As indicated earlier, I don’t advocate custodial accounts for very large dollar amounts, and the income tax benefit for relatively small amounts is likely to be negligible. In short, although there is a potential income tax advantage in using an UGMA or UTMA account, the benefit usually isn’t large enough to justify a gift you are not otherwise inclined to make.