Custodial Account Tax Implications

If you want to invest in a child’s financial future, setting up a custodial account on their behalf is an incredible first step in doing so. 

By setting up a custodial account for a child, you’ll be able to make your financial contributions work harder and ensure that they’re able to build a nest egg big enough to offer them the incredible gift of financial freedom when they come of age.

That being said, it’s also important that you do your homework and understand all of the tax implications that go hand-in-hand with setting up a custodial account for a child you love. After all, custodial accounts can be a really tax-efficient way to save for a child’s future — but you need to be aware of the tax law around custodial accounts.

This guide explains what a custodial account is, the capital gains taxes on custodial accounts, what the kiddie tax is, how the gift tax works, and who pays taxes on custodial accounts.

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What is a Custodial Account?

Before we get to the tax implications of setting up a custodial account, let’s slow things down and talk about what a custodial account actually is.

A custodial account is an increasingly popular investment vehicle that lets adults hold assets they want to pass on to a child when they come of age.

When you decide to set up a custodial account, you’ll choose a child beneficiary for that account. 

From the moment you start to place investments, cash, or other assets into the custodial account, they’re the legal property of that child beneficiary. 

But because the child isn’t old enough to make financial decisions on their own, it falls on you as the custodian to make any relevant management and investment decisions associated with that account.

When the child beneficiary hits the “age of majority” in their state, your custodianship over the account ends. In most states, the age of majority is either 18 or 21. At that age, they’re old enough to make their own financial decisions — and everything in the custodial account is then transferred directly to them.

That means they can use the cash you’ve invested to buy their first house, pay for college, fund a wedding, start a business, travel the world, or just put it in their own bank account.

There are two kinds of custodial accounts you’ll often hear about: Uniform Gifts to Minors Act (UGMA) accounts and Uniform Transfers to Minors Act (UTMA) accounts. 

Both the UGMA custodial account and UTMA custodial account are named after the pieces of legislation that created them, and they both allow adults to save for a child’s financial future.

One of the key differences between the two is that UTMA accounts let you hold less common asset classes. For example, with a UTMA, you could hold the deed to real estate property, fine art, or a U.S. patent. 

Meanwhile, UGMA accounts are designed to hold popular financial asset classes like cash, stock, bonds, exchange-traded fund (ETF) shares, and mutual fund shares.

Another key difference is that the age of majority for UTMAs can be a little bit higher than the age of majority for UGMAs in some states. And because the UTMA legislation wasn’t ratified in all 50 U.S. states, there are some places where you can’t legally set up a UTMA account.

For that reason, most families tend to go for a UGMA custodial account.

One of the major benefits of a UGMA account is that it’s tax-efficient. Because all the assets in a custodial account belong to the child rather than the adult managing the account, any unearned taxable income an account generates through dividends or compound interest gets taxed at the child’s lower tax bracket (at least up to a certain threshold).

For most families, this creates pretty large tax savings — but we’ll break down how in just a second.

What are the Tax Implications of a Custodial Account?

We’ve already mentioned that custodial accounts can be a smart way to invest for a child’s future while minimizing your tax burden. This is largely thanks to the so-called “kiddie tax,” as well as the “gift tax.”

With a custodial account, you don't have to worry so much about federal income tax or employment tax. But you are going to need to factor in investment income, short-term capital gains, and long-term capital gains as part of the tax liability you've got to manage.

Let’s dive into how these different taxes affect your tax bill on custodial account contributions.

Capital gains tax

As the custodian of a child’s UGMA account, it’s your responsibility to manage the assets and ensure every regulatory box gets ticked on behalf of that child.

Translation: when tax season rolls around, it’s going to be your job to file the relevant tax forms and ensure that taxes are getting paid on any capital gains and unearned investment income the account has been generating for that tax year.

Fortunately, because the assets in a custodial account are the property of the child beneficiary, capital gains are taxed differently than normal assets owned by an adult — but only up to a certain point.

This is known as the “kiddie tax,” and it has the potential to save you a lot of money on any capital gains a child’s account generated in unearned income.

The kiddie tax

The kiddie tax is a rule that the Internal Revenue Service (IRS) introduced in the 1980s as a new way to prevent American taxpayers from avoiding their tax bills by simply “giving away” their investments to their children.

That being said, even the IRS acknowledges that many adults genuinely want to give investments to future generations to help them build a brighter future. That’s why the kiddie tax offers a bit of a compromise that both allows you to invest for kids while also preventing you from dodging taxes.

Simply put, the kiddie tax is a charge levied on any unearned income a child generates from sources other than employment. By “sources other than employment,” we’re normally talking about dividends and payments from compound interest.

This sort of income is pretty common if an adult is investing on behalf of a child using a UGMA custodial account because there will likely be stock shares or another type of security in the account generating annual dividends.

The compromise the IRS added into the kiddie tax is that it only kicks in after a certain amount of unearned income has been generated.

For the 2023 tax year, unearned income under $1,250 qualifies for the so-called standard deduction. The next $1,250 worth of unearned income is taxed at the child’s lower tax rate. This rate is usually pretty low (sometimes, it can even be zero).

Anything over $2,500 is then taxed at the adult custodian’s tax rate, which could be a whole lot higher.

It’s worth noting these amounts were increased from the 2022 tax year, when the threshold was $2,300.

If a child’s unearned income is above the kiddie tax threshold, a parent has two options for filing the child’s tax return. They can either include the child’s income on their own return or file a separate return on the child’s behalf.

You also should remember that the kiddie tax threshold only applies to unearned income a child’s assets have generated. Ordinary income that the child earns through part-time employment doesn’t count — so if the child you’re saving for earned $1,000 mowing lawns, that’s taxed differently.

The gift tax

The other major tax implication to be aware of when setting up a custodial account is the gift tax.

The IRS gift tax is a levy that the IRS imposes on the transfer of any property from one person to another whenever the person giving the gift gets little to nothing in return. The gift tax applies to all types of property — whether or not you as the donor intend for your transfer to be a gift.

It’s also critical to understand the gift tax kicks in if you accept payment for an asset that’s way below the fair market value. For example, let’s say you buy a fancy new motorcycle for $30,000. But then you immediately turn around and sell it to your nephew for $5,000.

For tax purposes, that sale is below fair market value because the purchase price was so much higher than the sale price. That means it’ll likely count as a gift. 

Interest-free loans and reduced-interest loans also normally count toward the gift tax, and so it’s important to understand the tax implications of any loans you may be offering to friends or family at generous rates.

But just like the kiddie tax, the IRS does understand adults want to gift assets to their loved ones. That’s why the gift tax exemption was introduced.

The gift tax exemption is often referred to as the “gift tax limit,” but both terms mean the same thing. This allows you to give up to a certain value in assets to people per year and over the course of your lifetime, tax-free.

Single tax filers in 2023 can give up to $18,000 per person per year totally tax-free (an increase from $16,000 in 2022). That means you could give $18,000 to your son, $18,000 to your daughter, and $18,000 to your little cousin all in the same year without increasing your tax burden.

If you and your spouse are joint filers, that gift tax limit automatically doubles to $36,000 per couple per year.

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That’s your annual gift tax limit. But you’ve also got a lifetime gift tax limit that kicks in after the annual limit, which is $12.92 million (an increase from $12.06 million in 2022). Again, that amount is higher if you're married filing jointly.

Any time you gift someone an amount that exceeds your annual gift tax limit, you need to report that gift to the IRS. But more important still, that spillover then gets counted against your lifetime gift tax limit.

If you need to report a gift to the IRS, you must complete and submit IRS Form 709 (the “gift tax return”) alongside your ordinary tax return.

Who Pays Tax on a Custodial Account?

In terms of tax implications, the final point to bear in mind is who pays taxes on a custodial account.

Although everything in a custodial account belongs to the child beneficiary, kids aren’t expected to sit down every year and fill out an income tax return. That means as the custodian of a UGMA account, it’s going to be your responsibility to file the relevant tax forms and make sure that capital gains taxes are paid.

If a child’s custodian account ends up generating unearned income for a given tax year, this needs to be reported to the IRS. To do so, you need to complete Form 8615. This can then be sent into the IRS alongside the child’s IRS Form 1040.

That being said, you might not have to file a separate tax return. If the child you’re filing for only generated unearned income through dividends, interest, and capital gains from mutual funds, you’re allowed to include their income on your own 1040.

Just remember — you’ll then be responsible for paying whatever tax is owed on your tax return. If you decide to go with this route, you’ll also need to complete and submit IRS Form 8814 alongside your return.

Remember that if you’ve gifted a child above the annual gift tax exclusion of $17,000 per person per year, you’ll also need to include a gift tax return alongside your 1040.

Conclusion

Setting up a custodial account is an intuitive and tax-efficient way to save for a child’s financial future.

It’s also important that you truly understand the tax implications of setting up a custodial account. 

This includes knowing when and how the kiddie tax kicks in on gross income, as well as your gift tax limits. Likewise, you need to do your homework and know your responsibilities as a UGMA custodian where taxes are concerned.

But as long as you know the lay of the land, starting a custodial account is an amazing way to give the kids you love a gift that’ll withstand the test of time.

So, are you ready to start investing? Download EarlyBird now.

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