Are Withdrawals Taxed in a Custodial Account?

Custodial accounts are a good way to involve your child in investing.

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Custodial accounts are financial accounts opened for the benefit of a minor. They are a convenient way to get your children involved in investing or to invest gifts or earnings they receive. Until they reach legal adulthood -- age 18 to 21, depending on the state where the account is opened -- minors cannot open brokerage accounts, so custodial accounts are an alternative. In addition to cash, stocks and bonds, custodial accounts can also include assets like real estate and royalties.

About Custodial Accounts

Custodial accounts come in two basic types named for the laws that created them: Uniform Gifts to Minors Act (UGMA) and the Uniform Transfer to Minors Act (UTMA). The main difference between them is the type of assets they can include. UGMA accounts are limited to cash, stocks, bonds, mutual funds and insurance policies, while the UTMA accounts can include other types of assets such as real estate, royalties, patents and inheritances. The custodian who opens the account might get input from the child, but she is responsible for all decisions regarding the account, including what goes in and how it is invested.

Tax Treatment

Earnings in custodial accounts are taxed annually. As of 2013, the first $1,000 is tax exempt, while earnings over $1,000 are subject to tax. Selling an asset, such as a stock or mutual fund, that results in a profit may incur federal and state capital gains taxes. This is true whether you withdraw the proceeds or not. Say Bob opened a custodial account for his son Tommy in 2011 and purchased 100 shares of stock in XYZ Company for $15 each. In 2013, Tommy wants to attend a tech camp that costs $500. The stock is now valued at $20 a share and Bob sells 25 shares to cover the cost of the camp. Bob’s capital gains rate is 15 percent. Because he made a profit on the sale of the shares, Bob could calculate his tax liability using the following method: $5 ($20 selling price - $15 cost basis) x 25 shares x 0.15 (capital gains rate) = $18.75

Impact on Student Aid Eligibility

For financial aid purposes, custodial accounts are considered assets of the student and can greatly affect the amount of financial aid the child can receive. If this is a concern, consider alternatives such as 529 plans -- accounts that are treated as assets of the parent and have less effect on the student's financial aid prospects.

Additional Considerations

Custodial accounts are set up for the benefit of a minor, so the minor owns it. When he reaches legal adulthood, he takes control of the account and determines how to use the money and assets. The adult account owner doesn't need permission from the custodian to use the funds and is not required to use the money for college.

Photo Credits

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About the Author

Based in Atlanta, Patricia Stallworth has been writing finance-related articles since 1999. She is the author of several books including "Minding Your Money," which was featured in the Wealth Building series in “Black Enterprise” magazine. She has a MBA in finance and a BS in education.

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