Custodial Accounts for Kids
Posted on: February 22, 2025 by Martin Curiel, CFA in Tax Strategy
Key Benefits: Custodial accounts foster real-world financial skills while potentially reducing a family's overall tax burden by shifting certain investment gains to the child's lower tax rate.
Tax Advantages: The first $1,300 of investment income is tax-free (2024), with the next $1,300 typically taxed at the child's lower rate, creating significant tax savings opportunities for families.
I studied Engineering at Cal Poly, where I learned to fully embrace the school's motto of "Learn by Doing." That same philosophy has shaped my views on financial literacy—there's simply no substitute for hands-on experience, especially when it comes to managing money. And the earlier children start, the better. That's why our firm frequently recommends custodial accounts for younger kids. Not only can these accounts foster real-world financial skills, but they can also help reduce a family's overall tax burden by shifting certain investment gains to the child's lower tax rate.
In this article, we'll explore the mechanics of custodial accounts, how they can be used to teach children about money, and the practical steps involved in maximizing their tax benefits.
The Basics of Custodial Accounts
Children under the age of 18 typically cannot open or control financial assets in their own name. A custodial account overcomes this limitation by designating an adult—often a parent or guardian—as the custodian. This arrangement allows the adult to manage the account's investments and transactions until the child reaches the legal age of majority (18 or 21, depending on the state and the type of account and state law).
Maximizing Tax Efficiency
For families in high-tax states like California or New York, long-term capital gains can reach 35% or more. A custodial account allows you to realize some of those gains at the child's much lower tax rate—often resulting in significant savings.
A Simple Example
Imagine a parent purchased 100 shares of a stock at $20 per share (total cost $2,000). If the shares are now worth $360 each, the position's market value is $36,000, and the total unrealized gain is $34,000.
Tax Treatment (2024):
- • First $1,300 of Investment Income – Tax-free for the child
- • Next $1,300 – Taxed at the child's rate (often around 6–10%)
- • Above $2,600 – Taxed at the parent's marginal rate (the "kiddie tax" rule)
Note: The kiddie tax applies to children under 19, or under 24 if they are full-time students.
Using the Money
Once gains are realized in the custodial account, parents have a few options:
1. Invest for Future Growth
Continue investing within the custodial account, focusing on keeping annual investment income below the $2,600 threshold (2024).
2. Reimburse Child-Related Expenses
Pay for expenses that directly benefit the child—day care, summer camps, extracurricular activities, etc.
3. Fund a 529 Plan
Transfer proceeds into a 529 plan for tax-free growth on qualified education expenses.
Building Financial Literacy
Beyond tax efficiency, custodial accounts present a unique hands-on learning opportunity for children:
| Learning Area | Educational Benefit |
|---|---|
| 1. Budgeting & Expense Tracking | Involve children in tracking expenses paid from their account, helping them understand the cost of various activities and services. |
| 2. Investing & Market Exposure | Use real money to teach about risk vs. reward, asset classes, diversification, and long-term investing principles. |
| 3. Tax Basics | Provide hands-on experience with tax returns when investment income exceeds $1,300 (2024). |
Important Considerations
Key Points to Consider:
- Additional Tax Returns
- Required if child's annual investment income exceeds $1,300 (2024)
- Generally simple returns, often covered by our firm for full-service clients
- Ownership Transfer at Age 18 or 21
- Age depends on state law
- Child gains full control of funds at majority
- Restrictive Yet Broad Usage
- Must benefit the child, but definition is broad
- Proper documentation required
- The Curse of a Large Custodial Balance
- Can reduce financial aid eligibility by 20-25%
- Compare with other vehicles like 529 plans
Summary
For many of our clients, a custodial account is a versatile tool that achieves multiple goals simultaneously: it can offset the family's tax burden, fund a wide range of child-related expenses, and—perhaps most importantly—serve as a real-world classroom for financial education.
Key Strategy Points:
- Keep an eye on annual investment income thresholds
- Decide whether to reinvest proceeds or use for immediate expenses
- Stay mindful of the child's eventual control over the account
A closing thought. My 11-year-old daughter has been investing since she was 8. While she doesn't love it, she understands that financial literacy is a skill she'll use for life. It's a reminder that starting early is key, even if it's not always exciting. In the end, custodial accounts combine financial advantages for the parent with invaluable learning experiences for the child—truly a win-win for families looking to build wealth and knowledge across generations.
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