When it comes to teaching kids about investing, a custodial brokerage account can be a great way to go. "Gifting kids investments or cash via custodial accounts—and then teaching them how to research and manage those assets—can lead to better investing habits in adulthood," says Chris Kawashima, CFP®, a senior research analyst at the Schwab Center for Financial Research.
Once children reach the "age of majority"—typically 18, 21, or 25, depending on the state—they gain control over the account and can use the funds however they see fit. "You can't control what they ultimately do with the funds," cautions Chris, "but if you communicate your values along the way, your child may be more likely to follow the path you intended."
If this route sounds right for you, here are three things to know before opening an account:
- Gifts are irrevocable: Contributions to a custodial account are considered irrevocable—meaning you can't get that money back—and funds can be withdrawn by the custodian only to pay for expenses that would directly benefit the child before the age of majority. Note, too, that contributions that exceed the annual gift tax exclusion—$15,000 for individuals or $30,000 for married couples—may be subject to gift tax.
- Investment gains may be subject to the so-called kiddie tax: If any of the investments generate dividends or interest or are sold for a gain while the child is a minor, the first $1,100 of that income is exempt from tax, the next $1,100 is taxed at the child's single-filer rate, and anything beyond $2,200 is taxed at the parents' rate.
- The funds can decrease financial aid eligibility: Federal financial aid formulas—which determine eligibility for federal loans, grants, and even some scholarships—consider 20% of a student's assets, including the custodial account's value, as available for educational purposes. On the other hand, only 5.6% of parental assets (including 529 college savings accounts) are considered in the calculations.
What's more, it's important to consider your ultimate goals for the money. If you're hoping to help your child or grandchild save for college or get a head start on retirement, for example, funding a special-purpose account like a 529 or a Roth IRA may be a better way to go.
"Those accounts provide unique tax advantages that a custodial account doesn't," Chris says. "But if you're looking to instill an enthusiasm for and appreciation of investing, custodial accounts are a great place to start."