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What is a Custodial Account? - Definition & Rules

Instructor: Elizabeth Branum
A custodial account is a special type of account used to set aside money for another party. In this lesson, which focuses on custodial accounts created for minors, we will define custodial account, explain the associated rules, and discuss the tax implications for this investment tool.

Definition

A custodial account is a financial account opened for the benefit of another person, called the beneficiary. The person who opens and continues to manage the account is referred to as the custodian. A custodial account is generally appropriate when someone desires to establish an investment account for a minor, is willing to take control and manage the account and its investments, and understands that the account is set up as an irrevocable gift to the minor.

General Rules

The Uniform Gifts to Minors Act (UGMA) allows a minor to own an investment account and provides the mechanism to transfer an investment account to a minor without the need for a formal trust. A minor child's custodial account must be established under the applicable state's UGMA law. As soon as the custodial account is created, the money in the account is legally the property of the beneficiary, and the custodian has a fiduciary (good faith) duty to manage the account in the beneficiary's best interest. In the occasion that the selected custodian is unable to continue in the role of custodian, an alternate custodian can be designated to take over the role until a custodian is no longer needed. The minor gains control over the account when he or she becomes of legal age (usually 18 but sometimes higher) in the state where the gift was made.

Contributions

There are no contribution limits associated with a custodial account. However, any amount contributed to the minor's account over $14,000 must be reported by the donor in a gift tax form (IRS Form 709) in the year of the contribution. In addition, transfers into custodial accounts for minors are permanent. This means that once the transfer to the custodial account is complete, those funds belong to the minor. Transferring the funds back again is an enormous challenge. Even if the minor consents to returning the funds, he isn't of legal age to consent for the transfer. If there are any doubts about the availability of the funds in question, the custodial account should not be used.

Investment Income and Taxes

Any investment income from the minor's custodial account belongs to the minor, and income taxes may need to be paid on the investment income attributable to this account. Due to the 'kiddie tax', any investment income above $2,100 will be calculated based on the parents' rate. In addition, state and local income taxes may also be due.

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