Advantages and Disadvantages of Custodial Savings Accounts

Custodial savings accounts are bank accounts set up by a parent for a minor child that can contain either savings accounts, CDs, or a combination of both. In fact, most general custodial accounts can also contain stocks and bonds. The money deposited into a custodial account becomes the property of the child but cannot be withdrawn without permission from the custodian until the child reaches adulthood (between 18-21 depending on the state).

Custodial accounts have several advantages and disadvantages as a savings vehicle for minors.

Advantages

• Safety. Money placed into a custodial savings account cannot be withdrawn or used without the permission of the custodian.
• Flexibility. The money, with custodian permission, can be withdrawn at any time and used for any reason. Money in 529 Plans can only be withdrawn for college expenses.
• Potential tax advantages. Some minors may benefit from tax savings by placing their funds into a custodial account. Individuals under 18 (or 24 if a full-time student) do not need to pay tax on the first $850 in interest income generated from the account. The next $850 is taxed at the child’s income level, usually low. Any income over $1,700 is taxed at the custodian’s income, which can be substantially higher. Thus, if a child is generating significant income from the account, a custodian account may create a significant tax burden. For interest income below $1,700, custodial accounts offer tax benefits.

Disadvantages

• Money is Theirs. Once the money is given to the child in the custodian account, it is theirs. Legally, the money can only be used for expenses that benefit the child. And once they reach adulthood (18-21), they can spend it on whatever they want. The flexibility is a double-edged sword.
• Tax Disadvantages. If the account generates more than $1,700 in investment income and the custodian has a high tax rate, the account will generate a significant tax bill for the minor. Over 30% of the income from the account could be taken in taxes. 529 Plans on the other hand allow contributions to grow tax deferred, and distributions used to pay for college come out federally tax-free.
• Financial Aid Penalty. Money in a custodial account is counted as part of a student’s assets when they apply for financial aid. This may negatively impact the aid application.

Eligibility & Contribution Rules

Any adult can set up a custodial savings account for a child under 18 years of age. There is no limit to the amount that can be contributed to these accounts but parents should be aware of the potential tax ramifications of depositing significant cash and generating sizable income from the account.

Transferability

The funds in a custodial account cannot be transferred to another child, unlike 529 plans and Coverdell ESA’s.

Where to Open

Many banks offer custodial savings account for minors under 18.