What is a deposit brokerage account?
As a parent, you want to make sure that you are preparing your children for every possible success. Part of that is supporting them financially while they’re under your roof. Another is to set the stage for them to thrive when left alone.
Some people do this through child-only savings accounts or 529 accounts, although these have their own limitations. Savings accounts typically offer much lower returns than you might expect from investing in the stock market – in fact, they may not even keep up with inflation (the rate at which prices rise).
Although 529 accounts offer exposure to the wealth-building potential of the stock market, they come with certain restrictions, namely that they cannot be used for anything outside of education without incurring penalties. .
Another option for forward-thinking parents: the custodial brokerage account.
What is a custodian account?
Deposit brokerage accounts allow you to invest for your children (or any of the children in your life) the same way you invest for yourself. Custody brokerage accounts can be opened with a financial institution in the child’s name, and then you, your friends and family can contribute money towards that child’s future. You can generally contribute up to $15,000 a year without incurring gift tax.
Money in the account can generally be invested in the same types of stocks, bonds, mutual funds, and exchange-traded funds (ETFs) that you might hold in your own Individual Retirement Account (IRA) or brokerage account. You may also be able to invest in pre-made, managed investment portfolios, such as those offered by Acorns.
Unlike traditional investment accounts, deposit brokerage accounts come with a few restrictions. The big one is that ownership is automatically transferred to the child when he reaches the age of maturity, the threshold of majority recognized by law. It’s usually 18 or 21, depending on the state where he or she resides. Prior to this date, funds may only be withdrawn if used for the direct benefit of the child.
And any investment income (such as dividends, interest, or gains) generated in the account is considered to belong to the child and taxed.
Custodial brokerage accounts can be classified as UGMA (Universal Gift to Minors Act) or UTMA (Universal Transfer to Minors Act) accounts. These classifications refer to the laws that allow you to give assets to your children.
UGMA vs UTMA Deposit Accounts
The main difference between UGMA and UTMA deposit accounts is that a UGMA account is generally limited to publicly traded financial products such as CDs, stocks, bonds, mutual funds, and insurance products. On the other hand, UTMA accounts, which were first created in 1986, can generally hold financial products as well as any form of property, including real estate or works of art.
Another difference between UGMA and UTMA accounts relates to state adoption. All states have adopted the UGMA. But two states, Vermont and South Carolina, still don’t allow UTMA accounts.
Why open a securities account for your child?
You may have heard the expression that it is the time in the market, not the timing of the market, that really matters. When you start investing early, you harness the power of time to optimize your investment results, allowing your child to enjoy long-term investment gains.
Over time, the gains made on your investments accumulate, which means that their returns get their own returns, and so on. This is the power of compounding in action. Start investing even a small amount after your kids are born, and you could gift them 18 years of compounding or more.
Deposit account vs traditional brokerage account
Traditional brokerage accounts and custodial brokerage accounts both allow you to invest for your child through stocks, bonds, mutual funds, ETFs, and other investments. Money from each can be used for education or a myriad of other purposes (once your child takes ownership of the custodial account), but the two differ in a few key ways:
You control the money in a traditional brokerage account
When you invest for your child in a brokerage account in your name, you can access funds at any time. You can also choose when or if you want to gift money to your child. Control of a custodial brokerage account, on the other hand, is automatically transferred to your child at 18 or 21 depending on your state of residence. (Some states may also allow you to choose an older age.)
Traditional brokerage accounts offer no tax advantages
Although deposit brokerage accounts are still subject to tax on investment gains, the first $1,100 may be exempt from tax each year. The next $1,100 is often taxed according to the child’s tax bracket (usually 10%). Once the earnings reach approximately $2,200, they will be taxed using brackets and rates for trusts and estates, which may actually be higher than parent tax rates. This is called the Kiddie tax.
Deposit account vs 529
If investing for kids is on your radar, you might be more familiar with 529 accounts, a special type of investment account that offers tax benefits to those investing for kids’ college expenses. Custody brokerage accounts and 529 accounts allow you to invest for your children’s future, and both can be used for education costs. But they have some important differences:
529 accounts offer tax benefits
These include potential income tax deductions (depending on your state of residence) and tax-free growth (if used for educational expenses). Funds held in deposit brokerage accounts, on the other hand, may result in your child having to pay income taxes, depending on how much money they earn in a given year.
Account 529 funds can only be used for eligible educational expenses
While 529 accounts can be a great option for college or other education savings, you’ll incur a 10% penalty (plus possibly income taxes) on any amount you withdraw that isn’t not used for eligible education expenses. “Educational expenses” have expanded to include forms of education outside of college or university, such as trade schools.
But any use outside of this expanded definition may result in taxes or penalties. Funds held in custodial accounts can be used as your child wishes after taking possession of them. Before that, you can use them in any way that directly benefits your child, such as school expenses or clothing.
Account 529 funds can be used by other family members
Even if there is a named beneficiary on a 529 account, the account holder can change it to another family member, such as a sibling or even one of the parents themselves, if a child chooses not to. use funds 529. Custody brokerage accounts, conversely, irrevocably become the property of the designated child and may only be used, even by a parent, for the direct benefit of the child.
Your child’s financial assistance may be affected by a custodial account
Since all assets held in a deposit brokerage account legally belong to your child, they weigh more heavily in Free Application for Federal Student Aid (FAFSA) calculations. Funds held in 529 accounts are considered less heavily.
Benefits of Opening a Deposit Brokerage Account
You and others, including family and friends, can invest in your child’s future
Deposit brokerage accounts allow you and others to pay money to your child that you can then invest on their behalf. Depending on the amount, some may be subject to gift tax. Although you can normally give up to $15,000 a year without incurring gift tax, consult your tax or financial advisor for more information.
You probably have access to a wider range of investment options
One of the main complaints with 529 accounts is the relative lack of investment options available. Instead of being able to invest in hundreds (or thousands) of different stocks, bonds, and exchange-traded funds (ETFs), for example, you may be limited to a handful of target date or mutual funds. shift. Deposit brokerage accounts, on the other hand, offer investment options similar to those you might have access to in your own brokerage account.
You won’t pay taxes on money held in your child’s account
Although custodial brokerage accounts don’t offer quite the same tax advantages as 529 accounts, they are not without potential tax advantages. Any dividends or investment income paid into a deposit brokerage account is technically your child’s investment income and should be reported as such. When they have small balances, it could mean that that income sees little or no tax.
Other Considerations with a Custody Brokerage Account
Your child will take control of the account at 18 or 21
In most cases, once your kids turn 18 or 21, full control is theirs. This means that they can continue to invest in it, they can liquidate it immediately, or they can withdraw from it regularly over time. This is different from 529 plans, which parents control and can even use for the education of other family members or for themselves.
Any contribution belongs irrevocably to your child
As soon as the money reaches your child’s custody brokerage account, it’s theirs. While that doesn’t mean you can’t withdraw it, it does mean you can only do so for expenses that directly benefit your child. This can range from rent to clothes for your child. While it is not as restrictive as the 529 account requirement that funds be used for education, it is not as unrestricted as a brokerage account held in your own name.
Your child may owe taxes
You may get a little tax relief when you put money in a deposit brokerage account (instead of growing it in your own account), but your child could be liable if they earn more than 1,100 $ in investment income. They could face even higher taxes once that amount exceeds around $2,200. Check with your tax or finance professionals for more information on how your child’s custody brokerage account might be affected by taxes.