What Parents and Grandparents Need to Know About Custodial Accounts

Parents and grandparents establish custodial accounts for children for various reasons. For example, grandma might want to set aside $10,000 for her granddaughter, or maybe Mom and Dad want a tax shelter for their child’s savings. However, many folks who establish custodial accounts fail to recognize these accounts have significant legal and tax implications.

Here are five important facts parents (and grandparents) need to understand.

1. The Money Now Belongs to the Child

Once transferred into a minor child’s custodial account at a financial institution or brokerage firm, the funds irrevocably belong to the child. While the parent or guardian usually acts as the custodian (manager) of the account, the money can legally be used only for expenditures that benefit that child. In other words, parents legally can’t use custodial account money for expenditures that benefit themselves (like a new car). Parents also can’t take money from one child’s custodial account and use it to open up or supplement an account for another child.

While it’s rare for parents to face legal trouble for misusing custodial accounts, be mindful of this requirement to avoid potential issues.

2. The Child Will Gain Control at a Relatively Young Age

Parents or grandparents must establish a minor child’s custodial account under the applicable state Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA). Most states have UTMA regimes these days. In any case, under applicable state law, the child will gain full legal control over the account once he or she ceases to be a minor. This will happen somewhere between 18 and 21 — in most states, the magic age is 21.

Remember, small children eventually may turn into teenagers and young adults who are not responsible with money. It’s important to consider the possibility of future “UGMA or UTMA regret” before taking the irrevocable step of putting a substantial sum into a child's custodial account.

3. The Child May Have to File Tax Returns and Pay Taxes

Any income from a child’s custodial account belongs to the child. If that income exceeds certain thresholds, you’ll need to file a separate federal income tax return for the child using Form 1040. The child will probably owe some tax, and the Kiddie Tax rules may make it higher (read more about the Kiddie Tax below). A state income tax return may also be required.

Exception: If all of the child’s income consists of interest, dividends and mutual fund capital gain distributions, the parent may be able to simply include the income on their own Form 1040 and pay the resulting extra tax with that return. Details about this option are explained on IRS Form 8814, Parents' Election to Report Child's Interest and Dividends.

4. The Kiddie Tax Might Apply

Ideally, children with substantial custodial accounts would be taxed at the same rates as other individuals with similar income. If that was allowed to happen, a child’s ordinary income would typically be taxed at a federal rate of only 10% or 22%, and a 0% or 15% rate would typically apply to long-term gains and dividends.

Unfortunately, the Kiddie Tax prevents this.

As of 2024, the first $1,300 of a child’s unearned income is tax-free, and the next $1,300 is taxed at the child’s rate. However, any unearned income over $2,600 is taxed at the parent’s rate. This is true even if all the money to fund the custodial account came from a grandparent or someone other than a parent. Therefore, if the parent is a high-income individual, the federal income tax rate on a child’s interest income could be as high as 37%, with long-term gains and dividends taxed up to 20%.

Use IRS Form 8615, Tax for Certain Children Who Have Unearned Income, to calculate tax on unearned income over $1,300 for those under age 18 or on the aforementioned Form 8814 (when allowed).

Important point: Custodial accounts were once a reliable way to achieve tax savings since income was taxed at a child’s lower rates. The Kiddie Tax rules have largely reduced these benefits, so custodial accounts are not as effective for tax sheltering as they were previously.

5. There Could Be Gift Tax Consequences

A parent can take advantage of the annual federal gift tax exclusion to move up to $18,000 (in 2024) into a custodial account for each of his or her children. For married couples, this limit doubles to $36,000 per child. Parents can do the same thing year after year. Gifts up to the $18,000 annual limit will not reduce the parents’ unified federal gift and estate tax exemption, which is now $13.61 million per individual as of 2024.

However, if a parent transfers more than $18,000, they must file a gift tax return on IRS Form 709, United States Gift and Generation-Skipping Transfer Tax Return, even when no gift tax is due. Thanks to the generous exemptions, the parent will probably not owe any gift tax but should still file a gift tax return.

The same gift tax considerations apply to gifts by grandparents and others.

Alternative Options to Custodial Accounts

Consider these additional options to transfer funds for the benefit of children or grandchildren:

• College Savings Plans (529 Plans): A “superfunding" contribution of up to $90,000 per parent or grandparent (as a one-time lump sum) is allowed per child. These accounts remain under parental or grandparental control and grow tax-deferred, with funds remaining tax-free if used for qualified education expenses. Some states also offer tax benefits for contributions. Leftover funds can also roll over to a Roth IRA.

• Trusts: Setting up a trust provides longer-term control over the gifted assets, establishing terms that restrict a child’s access until the age you specify. This can be ideal for larger gifts, ensuring the funds are used responsibly.

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