There are two primary types of custodial accounts: individual retirement accounts (IRAs) and custodial accounts for children.
Individual Retirement Accounts
An individual retirement account is an investment account designed to help people save for retirement. Its tax benefits vary depending on the type of IRA you have and how much you contribute.
There are four main types of IRAs: 1. Traditional IRA: This retirement account allows for tax-deductible contributions using your pre-tax income. When you withdraw from it, you’ll likely pay taxes on the funds you take out.
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2. Roth IRA: A Roth IRA lets you grow the account tax-free. You contribute to a Roth IRA with your post-tax income and generally won’t pay any additional tax if you follow the regulations.
3. SEP-IRA: This stands for “simplified employee pension individual retirement account.” Self-employed people, small-business owners, and independent contractors, primarily use this type of IRA.
Contributions are from pre-tax income. 4.
SIMPLE-IRA: This stands for “savings incentive match plan for employees individual retirement account.” Small businesses with a maximum of 100 employees can use this type of IRA.
Contributions come from your pre-tax income.
The Internal Revenue Service requires that all IRAs be a trust or custodial account.
The custodian must be a bank, a savings and loan association, a federally insured credit union, or another IRS-approved institution.
Custodial Accounts for Children
Custodian accounts protect the money you want your child to have in the future.
No one but the beneficiary can withdraw from the custodial account. That also means that creditors and other family members can’t touch the funds, and neither can the person who deposited them.
A custodian keeps the assets secure until the minor reaches the age of majority.
🤔 Understanding custodians
You can set up a few different custodial accounts for minors. Here are the three main options:
Uniform Gift to Minors Act Developed in 1956 and revised a decade later, the Uniform Gift to Minors Act (UGMA) allows parents or other relatives to transfer assets — such as cash, stocks, bonds, and insurance policies — to a minor without creating a special trust.
The framework was created at a federal level and adopted by individual states. The age when the beneficiary can take control of the assets varies by state, though most set the age at 18.
Uniform Transfers to Minors Act In 1986, the Uniform Transfers to Minors Act (UTMA) expanded on the Uniform Gift to Minors Act (UGMA) and made a few changes.
First, most states raised the age when beneficiaries can take control to somewhere between 18 and 25. The new law also expanded the definition of assets from monetary items, like cash and securities, to include property such as real estate, patents, and fine art. All states, except South Carolina, have adopted UTMA.
It’s important to note that you must pay taxes on your UGMA and UTMA custodial account contributions.
They also aren’t tax-deductible.
Although there is no contribution limit, you may want to keep the amount under $15,000 a year for a single tax-payer ($30,000 per year for a married couple filing jointly) to avoid the federal gift tax. The account is considered the minor’s asset, which may affect financial aid eligibility when he or she applies for college.
Coverdell Education Savings Account The Coverdell Education Savings Account (ESA) is slightly more restrictive than other custodial accounts for children. It has an annual contribution limit of $2,000. Although contributions are not tax-deductible, earnings can grow tax-free.
The beneficiary can use the funds to pay for what the Internal Revenue Service considers qualified education expenses.