My wife and I recently opened a custodial brokerage account for our 2-year-old daughter, Harlow. Our plan is to fund the account with $50 each month and invest it in ETFs, in line with my general investment strategy. The account will automatically transfer to our daughter when she turns 21 (option to transfer begins at 18). That gives us 19 years to invest before she’s legally able to take control of the account. Here is what the account’s growth might look like if we’re able to earn 7% per year ($50 starting balance, compounded yearly):
Custodial account gives flexibility
Our decision to open a custodian account was driven primarily by our desire for flexibility. We did not want to be limited in how we spend the assets for the benefit of our daughter. For example, the cost of youth sports is rising astronomically. And that doesn’t even factor in the cost for elite athletes who may be trying to earn a college scholarship.
Many parents save money in a college fund for their kids if they can. But how many are setting money aside today for the $3,000 elite travel team their kid will want to play for in 12 years? Where is that money going to come from? With our custodial account, we’ll have an extra set of savings that can be spent on such expenses. The same is true for unforeseen medical expenses. God forbid something bad happens to Harlow in the future, we could use money from the custodial account to help pay the hospital bill.
Simply put, kids are expensive. And it’s hard to forecast how expensive they’ll be and for what reason. So we really value having an investment account that gives us spending flexibility for our child. This is in stark contrast to a 529 plan, which can only be used for qualifying education expenses. Even a withdrawal made from a 529 plan to pay for an emergency medical bill would be subject to a tax penalty.
The education aspect
There’s more to custodial account flexibility than just spending options. We had the option of opening our custodial account at any major brokerage. We decided on Schwab because of their free commission policy and nice mobile interface. And we’re able to invest the money any way we see fit: ETFs, stocks, bonds, REITs, etc. Had we chosen a 529 plan, we would have had to go through the Illinois state website. In addition, our investment options would be limited to mutual fund portfolios only.
Even though we only plan to invest in broad market ETFs, a wide range of investment options can foster education. For context, Harlow already shows an interest in my work. When I am at my home office it’s not unusual for her to come in and ask me if I’m looking at charts (true story). So I could totally see her, at age 10, telling me she wants to buy a certain stock. And when that time comes, why not experiment and let her learn? With our custodian account, we’ll be better positioned to educate her on investing than with a 529 plan.
Custodial account tax ramifications
It is true that we miss out on certain tax advantages with a custodial account instead of a 529 plan. Assets in a 529 plan grow tax-deferred, similar to an IRA or 401(k). Also, contributions are tax-deductible up to $10,000 per parent. Assets in a custodial account do not grow tax-deferred and contributions are not tax-deductible. But because we’re only contributing $600 per year to start, any deduction would be pretty meaningless.
But what about the tax-deferred growth we miss out on? Well, if managed tactically, you can reduce any tax consequences in a custodial account. The first $1,050 in interest or capital gains in a custodial account is tax-free. The next $1,050 is taxed at 10%, and anything beyond that is taxed at the parent’s rate. So in our personal situation, there won’t be any capital gains for years anyway. Why? Because the portfolio will be so small these first few years that we won’t be doing any portfolio rebalancing. Thus, we won’t be at risk of triggering any capital gains since we’ll only be allocating to new or existing investments.
So the next possibility for tax would come from dividends or interest. Well, we’re not going to invest in any bond funds for the foreseeable future. So that eliminates any possible interest income. And the account probably won’t ever earn dividends totaling more than $1,050 in a year. Consider that, in 10 years, we forecast the account to be worth ~$8,500. If it earned 3% in dividends in year 10, that would equate to $195 total. In all of these situations, it’s extremely likely Harlow’s account is staying under $1,050 in total gains per year for the next 5-10 years. Therefore, we won’t trigger any taxes anyway.
A tax loophole
The fact our custodial account is likely to be under $40,000 when it legally transfers to Harlow is very important. At age 18, which is the earliest time Harlow can control the account, it’s unlikely she’ll be earning much income. This means her long-term capital gains rate would be 0% (the current rate in place since 2008 for her likely income bracket). So in theory, all of the gains in Harlow’s account could be 100% tax-free when she turns 18.
To recap, the main reason we opened a custodial account is to maintain flexibility. We have greater spending and investment options by opting for a custodial account instead of a state-sponsored 529 plan. In addition, we’re excited to use the account as a financial education tool in the future. And last but not least, through careful portfolio management, we’re confident we can mitigate taxes throughout the lifespan of the account. If you’d like to dive deeper into the pros and cons of a custodial account for your child, feel free to send me an email. Or you can send me a direct message on Twitter.
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