These Custodial Accounts Can Help Your Kid's Savings Grow Fast -- Without Too Many Restrictions

Do you want to start an investment portfolio for your child while they're young? Or do you want to set aside money for college, but not have to use it for educational expenses if they end up not needing it? A custodial account could be the solution.

Custodial accounts are a special type of brokerage account that allows parents (or any adult) to invest on behalf of a minor child. There are two major types, known as UGMA (Uniform Gift to Minors Act) and UTMA (Uniform Transfer to Minors Act). Both account types allow you to save money and invest it on behalf of a child until they reach the age of majority specified on the account, which is usually 18 or 21.

There's a subtle difference between UGMA and UTMA accounts. Specifically, UTMA accounts can own physical assets (such as real estate and fine art), while UGMAs can only hold financial products like stocks and mutual funds. And while UGMA accounts are available in all states, there are a couple (Virginia and South Carolina) that don't allow UTMA accounts. But in practice, if you're opening an account through a brokerage, there isn't much of a difference.

Advantages of using UGMA/UTMA accounts

There are a few big advantages to using UGMA and UTMA accounts to set aside money for your kids.

First and foremost, they aren't just for college. One of the biggest reasons parents are often hesitant to put money into a 529 plan is that the money must be used for college, or a penalty will be assessed. Money invested in a UGMA or UTMA account can be withdrawn for any purpose, or not withdrawn at all.

Second, you'll find more investment options in these accounts than with 529 plans. If you open a custodial account through a broker, you can use the money to invest in virtually any stocks, mutual funds, ETFs, bonds, or other securities you want.

There are also no contribution limits with UGMA and UTMA accounts. If you contribute large amounts, there could be gift tax implications, but that's true with most types of accounts when you contribute on behalf of another person.

Potential drawbacks

Money you put into your child's UGMA or UTMA account officially becomes their money. You can make investment decisions within the account until the child reaches the age of majority, but once they reach that age, you can't tell them what to do with the money. You can tell them you've set aside that money to help pay for college, or that you'd like them to leave it invested for years to come, but the reality is that they can legally withdraw it and spend it on whatever they want.

Plus, in the meantime, you can't change your mind and choose to take your money back out of the account -- once you deposit it into a custodial account, it cannot be withdrawn until the recipient reaches the designated age.

Speaking of college, an UGMA/UTMA account could affect your child's ability to qualify for financial aid. When your child fills out the FAFSA (Free Application for Federal Student Aid), they will have to list all of their assets as well as yours. Only up to 5.64% of parents' assets are counted as money that's available to pay for college, but as much as 20% of assets owned by the student are considered.

How to open a UGMA or UTMA account

If you think a custodial account is right for you, UGMA and UTMA accounts are available through many of our top-rated brokerage firms. In most cases, they can be easily opened online, and money can be transferred from a linked bank account quickly and easily.