My father had a custodial account for me and this year, I cashed it out. My father lost money on the whole, investing more than we've gained. What are the rules for custodial account taxes? Am I able to deduct the loss on my return?
A custodial account can be a valuable gift for any child. And while it's managed by an adult until the beneficiary reaches the age of majority (usually 18, or 21, depending on the state), the money always belongs to the beneficiary, not the custodian—so the gains or losses are yours, for better or worse.
As you've now experienced, a custodial account offers no special protection against losses. However, there can be a bit of a silver lining because the short answer to your question is "yes,"—when you realize a loss as you did by "cashing out," you can deduct it when you calculate your taxes.
Your decision to cash out raises a question of my own that I'll address later, but first let's talk about how you might turn those losses into a tax benefit.
Capital losses can offset capital gains
When you sell a security for less than the purchase price, you have what's called a capital loss. While no one likes to sell at a loss, there are certain potential tax advantages that can lessen the blow.
First, a capital loss can be used to offset a capital gain, as long as the sale took place in a taxable account. A custodial account fits that definition. So you need to look at the overall picture of your gains and losses when you cashed out your account.
For the sake of example, let's say that you sold $5,000 of stock ABC and realized a gain of $2,000. Theoretically, you'd owe capital gains taxes on that sale. However, let’s say that you also sold $5,000 of stock XYZ at a loss of $2,000. That loss on XYX would offset the gain on ABC, and you wouldn't owe any capital gains taxes.
Now if you sold other stocks and realized additional losses that went beyond any gains, you could end up with a surplus loss. That takes us to the next point.
Capital losses can be used to reduce taxable income
When your capital losses exceed your capital gains in any year, up to $3,000 can be used to reduce your taxable income. So if by cashing out your account, you realized $3,000 in losses beyond any gains, you can deduct those losses from your other income to potentially reduce your tax bill.
But what if you had more than $3,000 in net losses? You're still in luck because you can use those losses ($3,000 per year) in future years, without expiration. So let's say you had $12,000 in losses above and beyond your gains. You could use $3,000 the first year, and carry the remainder forward for the next three years.
So now what?
An accountant can help you with the paperwork necessary to properly file any capital losses. But, to me, the bigger question for you is what you're going to do with the money now that you've cashed out. If you have a specific use for it, that's great. But if it's just sitting in an account earning very little, I'd give some thought to your next steps.
You may have been disappointed by your father’s results, but that doesn't mean you should ignore the potential that long-term investing offers. When you're young, you have a lot of time ahead of you to make your money grow—and investing is one of the best ways I know to do that.
At the very least, if your employer offers a 401(k) or similar retirement savings plan, definitely contribute enough to get the company match (and more if possible). Or if you don’t have a retirement plan through work, I'd advise you to open an IRA and make the maximum contribution each year (as long as you have earned income).
Then, rather than being discouraged by the loss in your custodial account, use it as a lesson. Perhaps you can talk to your father about how he invested and why, and decide how you might now invest according to your own goals and feelings about risk.
Selling at a loss can be part of an overall investment strategy, but getting out of the market entirely can mean not only an immediate loss, but also the loss of future growth opportunities. Yes, investing always involves a certain amount of risk—but the upside potential over time can be significant. Give it some thought.
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