A custodial account is one created at a brokerage, mutual fund company or bank which is managed by an adult for a minor. The definition of a minor varies by state, and signifies an individual under the age of 18 or 21, depending upon current legislation. It can also refer to an account that is managed for eligible employees in order to pay for retirement benefits.
Under the terms of a custodial account the approval of the custodian is required if the minor wishes to make some sort of transaction. Most commonly the custodian is either the parent or the guardian, but it can be any legal adult. There are certain limitations regarding the types of funds or products owned by the account.
There are some disadvantages to these accounts. For example, funds transferred into a custodial account can’t usually be removed for other uses. Once the child hits that court appointed age, they have access to the money, regardless of their level of maturity. Custodial accounts may count against you when applying for financial aid for higher education as they are considered assets the child owns.
Among the advantages of custodial accounts is that they can be used to transfer financial gifts to minors while one is still alive; such gifts avoid estate taxes. If the child is paying a lower tax rate, having money in a custodial account may help reduce taxes paid. Finally, custodial accounts offer a minor the opportunity to manage some stocks and watch how saved money grows when handled properly, with guidance.
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Another disadvantage of a custodial account is that if the IRS goes after the custodian, it confiscates the child’s money, even when it is a relatively minor amount in the scheme of things. This shows that the IRS, in this situation, does not care about the best interests of the child, and does this just to be mean and nasty rather than to solve problems. It further shows that the custodian can not protect the child’s financial interests from the IRS when it has a claim against a custodian, rather than a child and that the IRS goes after children in these situations.