Defining custodial accounts and Coverdells

This article will ... Define what a custodial account is and describe the different types. List how funds in UTMA and UGMA accounts can and cannot be used. Note how some custodial accounts, like Coverdell ESAs, can be dedicated to educational costs.

You want your child or grandchild to have a good life, free from concerns about money. One way to help is to set aside savings and investments for them. But what’s a simple way that doesn’t require setting up a trust?

You might consider a custodial account for its flexibility — or a custodial 529 or Coverdell account for educational expenses. Understanding how to use these accounts, who they’re for, and how they can facilitate or hinder responsible life choices by young adults can help you decide what may be best for your family.

Custodial accounts: UGMA vs. UTMA

Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA) accounts allow adults, typically parents and grandparents, to open an account in a child’s name.

Minors cannot open bank accounts on their own without having an adult as a custodian or joint account owner. Custodial accounts allow minors to own securities, save cash, and sometimes hold real property and other assets. Any money the child earns — say, from a summer job — can also be placed in a custodial account.

The names might sound like something the federal government oversees, but these accounts are governed by state laws based on model legislation. The information in this article applies broadly but might not reflect the specific requirements in your state.

The UGMA, which is more restrictive about the types of assets that can be placed in the account, was adopted earlier than the UTMA. Every state has now adopted the UTMA, so we will only refer to UTMAs for the rest of this article.

One thing that is uniform across states is how the IRS treats custodial accounts. While there is generally no limit on how much money can be placed in a custodial account, there may be federal gift tax consequences for adults who contribute more than $17,000 (2023 limit) in a single year.

Adults must understand that once they put money in a child’s custodial account, they can’t take it back — not even to transfer it to one of the child’s siblings. And the child will gain full control of the account at their age of majority, which can be as young as 18.

Placing large sums into custodial accounts may not be advisable because of this lack of control; a trust may be a better choice. (Learn more: 7 situations where a trust might help)

It’s a good idea to review the options with a financial professional who can make recommendations tailored to your circumstances.

How custodial account funds may be used

As long as the child is a minor, the custodian can use the money in the account for purposes that benefit the child, as determined by state law. The custodian should keep a detailed accounting of these expenditures in case questions arise later. While rare, a child could sue a custodian if misuse of funds is suspected.

The account’s custodian can be the same person who donates the funds to the child or a different person. For example, a parent could be both the account’s donor and its custodian, or a grandparent could be a donor and name the parent as custodian. The choice of custodian may have estate tax implications that donors should discuss with their accountants or financial professionals.

Some of the more useful features of custodial accounts are:

They are easier to establish than trusts.
The money can be held in cash or invested in stocks, bonds, mutual funds, and potentially other assets as allowed by state law.
Investment earnings may be taxed at the child’s rate, which may be lower than the donor’s rate. (However, investment earnings over $2,500 may be taxed at the parents’ rate, under the so-called “kiddie tax.”)
They provide flexibility because the money doesn’t have to be used for a specific purpose, such as education.
Donors can contribute as much as they want and can contribute cash, securities, or other assets.

But there are some constricting features as well:

The custodian must use the money only for the child’s benefit.
The child, regardless of his or her behavioral maturity, will gain full control over the entire account balance at their age of majority, typically 18 or 21.
A child’s assets count heavily against college financial aid.
The donor’s gifts to the account are irrevocable.
There may be federal gift tax consequences for contributions of more than $17,000 per donee per year (2023).

Custodial 529 accounts

Sometimes, parents might establish an UTMA account for their child, then wish they hadn’t. They might be concerned that their child won’t use the money responsibly and want a way to regain control of the money. Or they might have established the account to save for college, then learned that other options may be better for securing financial aid.

“Money in an UGMA or UTMA is reported as a child asset on the FAFSA [Free Application for Federal Student Aid], reducing aid eligibility by 20 percent of the asset value,” said Mark Kantrowitz, publisher and VP of research for SavingforCollege.com.

One option that’s sometimes presented as a solution is to place UTMA funds into a 529 college savings account. Custodians may not realize that the result will be a custodial 529, not a regular 529. The rules of custodial accounts will still apply: the assets must be used for the child’s benefit, the beneficiary can’t be changed, and the child will gain full control of the account at the age of trust termination. (Learn more: 529 investment strategies: A primer)

One benefit of creating a custodial 529 account may be that by specifically earmarking the funds for college in this way, a parent may be able to influence a child to use the money for higher education. Another is that by placing the funds in a custodial 529, they will gain favorable treatment in financial aid calculations, counting toward about 5 percent of the expected family contribution instead of 20 percent.

Then there are the tax benefits of 529 accounts: assets grow tax deferred within the account and may be withdrawn tax free to pay for qualified educational expenses. And, starting in 2024, amounts in a 529 account can be rolled over into a beneficiary’s Roth IRA, up to a lifetime cap of $35,000.

A drawback is that there may be tax consequences when moving UTMA funds to a custodial 529 college savings account. Only cash, not securities, can be contributed to a 529 plan, which may mean selling securities and incurring capital gains taxes. And if the beneficiary doesn’t use the custodial 529 plan assets for higher education, a 10 percent tax penalty will likely apply when the money is withdrawn for another purpose.

Some custodians may choose to spend down UTMA assets to bolster their child’s financial aid, keeping in mind that assets must always be used for the child’s benefit. It’s important to consider the trade-offs inherent in such a strategy, since much financial aid comes in the form of student loans, which must be repaid with interest.

Talking to a financial professional with expertise in custodial accounts and 529 plans can help you make the best decision given the complexities of control, financial aid, and taxes. (Related: 10 mistakes to avoid with 529 savings plans)

Coverdell ESAs

Coverdell Education Savings Accounts (ESAs) are a type of trust or custodial account to which contributions can be made on behalf of a child younger than 18 or a special-needs beneficiary. These accounts are typically used by middle-income families who want to add another layer of college funding, or sometimes K–12 funding, on top of other options, such as UTMA and 529 accounts.

Individuals can contribute up to $2,000 per year to each designated beneficiary’s ESA. Contributions are not tax deductible, but the account’s funds will grow tax free until they’re distributed. Distributions are also tax free if they’re used for the designated beneficiary’s qualified educational expenses at an eligible educational institution.

The IRS limits the ability to contribute to an ESA based on income. In 2023, the donor’s modified adjusted gross income must be less than $110,000 for individuals filing solo tax returns; it must be less than $220,000 for taxpayers filing joint returns. Contribution limits are gradually reduced starting at $95,000 for single filers and $190,000 for joint filers. See IRS Publication 970 for details.

ESA contributions must be made in cash (which can then be invested in securities). The account balance must be distributed within 30 days of the beneficiary’s 30th birthday except in the case of a special-needs beneficiary.

The $2,000-per-year contribution limit is per beneficiary, not per donor or per account. Fortunately, ESAs can be used in combination with custodial and 529 accounts to set aside additional funds for a child’s education and other needs. This is a valuable feature, because ESAs can be more flexible than 529s when it comes to certain expenses.

“Coverdell education savings accounts can be used to pay for K–12 expenses in addition to college expenses,” Kantrowitz said. “Although the Tax Cuts and Jobs Act of 2017 added up to $10,000 a year in K–12 tuition to the qualified expenses from a 529 plan, there are still other K–12 expenses that are covered by ESAs and not by 529 plans.”

ESA funds can be used for qualified elementary, secondary, and higher education expenses that include tuition and fees, books, supplies, computers, internet access, and educational software. For K–12 education, ESAs may also be used for academic tutoring, school uniforms, and transportation.

Unlike custodial accounts, an ESA may be transferable to another family member if certain requirements are met. But under the rules of the ESA agreement, it may be the beneficiary who controls the transfer, meaning a parent’s wishes could be ignored.

College admissions counselor Kristen Moon, CEO and founder of Moon Prep, pointed out that ESAs have many limitations. However, in addition to the tax benefits, ESAs have the benefit of being treated as parent assets for college financial aid calculations and offering more investment options compared with 529 plans. (Learn more: A primer on college financial aid)

Conclusion

Helping your child or grandchild live a financially comfortable life that lets them earn a diploma, start a business, or see the world without worrying about money is an admirable goal. The account choices you make should not be undertaken lightly, however, as they might help or hinder such a goal.

Understanding the pros and cons of your many options, which include UTMAs, custodial 529s, ESAs, and more, is the first step toward deciding what may be best for your family.