Custodial Accounts for Kids: UTMA, UGMA and Custodial Roth IRAs

Want to give a child a financial head start? Custodial accounts are one way to save and invest on a child’s behalf. They can help build savings for a child’s future, teach them about investing and take advantage of decades of compound growth. But custodial accounts come with important rules about ownership, control and taxes that are worth understanding before you open one.

UTMA and UGMA accounts

Custodial accounts are established under state laws known as the Uniform Transfers to Minors Act, or UTMA, and the Uniform Gifts to Minors Act, or UGMA. These laws allow an adult, called the custodian, to manage money or investments for a child, called the minor or beneficiary.

UGMA accounts generally hold financial assets, such as cash, stocks, bonds and mutual funds. UTMA accounts can also hold other types of property, such as real estate, in states that allow it. Most states have adopted UTMA, though some account providers still offer UGMA accounts.

Custodial accounts can be opened at banks, brokerage firms and mutual fund companies. Parents, grandparents, other relatives and friends can contribute.

Contributions are irrevocable gifts

Contributions to custodial accounts are irrevocable gifts. Once money goes into the account, it legally belongs to the child. The custodian manages the account for the child’s benefit, but can’t take the money back or use it for their own purposes. Money withdrawn by the custodian must be used for the child’s benefit.

Contributions count as gifts for federal gift tax purposes. Gifts up to the annual gift tax exclusion amount per child don’t require filing a gift tax return.

When the child takes control

When the child reaches the age set by state law, often 18 or 21 depending on the state and account type, and in some states up to 25 if specified, they gain full control of the account. At that point, they can use the money for anything they want, whether that’s college, a car, travel or something else entirely. The custodian has no further say.

This transfer of control is one of the most important factors to consider. If you’re concerned about how a young adult might use the money, a custodial account may not be the best choice.

Taxes on custodial accounts

Investment income in a custodial account belongs to the child for tax purposes. Some investment income in a child’s account may be taxed at the child’s lower tax rate. However, larger amounts of unearned income can be taxed at the parents’ tax rate under the so-called kiddie tax rules, which are designed to prevent families from shifting large amounts of investment income to children to take advantage of lower tax rates.

Under kiddie tax rules, a portion of a child’s unearned income may be tax-free, the next portion taxed at the child’s rate, and amounts above a threshold taxed at the parents’ rate. The kiddie tax can apply to children under 18 and, in some cases, to full-time students up to age 24. Check irs.gov for current thresholds.

Custodial Roth IRAs

If a child has earned income, such as from a part-time job, babysitting, lawn mowing or other work, an adult can open a custodial Roth IRA on their behalf. Contributions can’t exceed the child’s earned income for the year or the annual IRA contribution limit, whichever is less. The money for contributions doesn’t have to come directly from the child’s earnings; a parent or grandparent can contribute on the child’s behalf, as long as the total doesn’t exceed the child’s earned income.

A custodial Roth IRA can be a powerful way to start long-term investing early. Because children have decades until retirement, even modest contributions can grow substantially through tax-free compound growth. Qualified withdrawals in retirement are tax-free. Contributions, though not earnings, can generally be withdrawn at any time without taxes or penalties, providing some flexibility.

Keep records documenting the child’s earned income, especially for informal work like babysitting.

Comparing custodial accounts with 529 plans

529 plans are designed for education and offer tax-free growth for qualified education expenses, such as college tuition, fees, books and certain room and board costs, along with limited K-12 tuition and other expenses. Many states offer tax deductions for contributions. The account owner, often a parent, retains control and can change the beneficiary.

Custodial accounts can be used for anything that benefits the child, offering more flexibility than 529 plans, but they offer fewer tax advantages and the child gains control at a certain age.

For financial aid, custodial accounts are generally treated as the student’s asset, which can reduce financial aid eligibility more than a parent-owned 529 plan, since student assets are assessed at a higher rate in federal aid formulas.

Some families use both, with a 529 plan for education savings and a custodial account or Roth IRA for other goals.

Teaching opportunity

Custodial accounts can be valuable teaching tools. Involving children in decisions about the account, explaining how investments grow and showing them statements over time can build financial literacy and interest in investing.

Think about control

Because the child gains full control at a certain age, consider whether that fits your goals before choosing a custodial account. If you want more control over how and when money is used, alternatives such as a 529 plan or a trust may be better choices. A financial planner can help you choose the right account for your family’s goals.