A custodial account requires a guardian who manages the account until the child is old enough to gain control of it. This guardian is referred to as a custodian. This person makes all the financial decisions regarding the account such as buying, selling, reinvesting, and so forth.

If the child wishes to have access to the money before the legal age, the custodian may take out money from the account for the child's benefit. Once the money is deposited into the account, it must be used for the child's benefit.

When the child turns the legal age, they may use the money for whatever they wish. In a few states, the custodian is granted the right to designate a different age for the child to receive the money. However, not all states allow you to designate this age.

UGMA's and UTMA's

There are two different types of custodial accounts- UGMA's and UTMA's. They work much alike with very few differences.

In 1956, the Uniform Law Commissioners created the Uniform Gifts to Minors Act (UGMA). This act was passed to make gifts and money available to minors. In the late 1980's, a new act was passed to help expand the different types of property that you can transfer to a child. This new law was named the Uniform Transfers to Minor Act (UTMA).

Advantages of Custodial Accounts

Custodial accounts allow a young investor to begin investing in stocks and mutual funds. Mutual funds allow you to select an option that allows you to designate the account as an UGMA/UTMA account. A young investor may also get involved with individual stocks by having a custodian apply for a custodial account with a broker.

Also, opening custodial accounts encourage good financial habits for the child. By having a child start investing at a young age, they are taking advantage of the benefits that come with investing. They learn about the stock market, managing money, and saving. It sends a great message to the child that may develop over time to promote good habits.

By appointing a custodian, there is slightly less risk involved with investing the money. It helps to prevent the child from losing all the money in the market because the custodian has to do the actual buying and selling.

Disadvantages of Custodial Accounts

Custodial accounts provide some excellent advantages for children, but unfortunately, there are some disadvantages.

First of all, when the child reaches the legal or specified age, they gain control of the account. Although this is what is planned from the beginning, some children will not use the money as you might wish or intend them to use it. Unfortunately, at age 18 or 21, most people aren't thinking about saving and investing. With this available money, they may be tempted to go out and blow all the money and be left with little or no money from those years of saving.

Another disadvantage is that the money cannot be revoked. This means that once the money is deposited into the custodial account, it is under the child's ownership. It may only be used for the child's purpose and may not be used for whatever unexpected expenses that the family might come across.

An Alternative to a Custodial Account

If you are uncomfortable with the fact that your child will have access to all that money and if you intend to use the money for their education, you may want to consider an educational IRA. This allows you to contribute up to $500 per year that must be used toward your child's education. Another great advantage with an educational IRA is that the money will grow tax-free.

Custodial accounts are great for encouraging children to learn about investing. Before opening up a custodial account, please weigh the advantages and disadvantages and consult the laws governing UGMA's and UTMA's in your state and decide if it is right for your child.

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