For many parents, the dream of building tax-free wealth for their kids often starts with familiar tools like Roth IRAs or 529 plans. However, these options come with restrictions. Roth IRAs require earned income, which most kids don’t have. Meanwhile, 529 plans limit flexibility, as funds must be used for qualified education expenses or face penalties.
If you’re looking for a strategy that offers the potential of tax-free growth and more flexibility, consider a custodial brokerage account, commonly known as a UTMA or UGMA account. In this article, we’ll explore how you can turn these accounts into powerful tax-free wealth-building vehicles for your children.
Why People Ignore Custodial Brokerage Accounts (And Why You Shouldn’t)
Custodial brokerage accounts often get overlooked because of a common misconception: that any gains or income within these accounts will be taxed at high rates. While custodial accounts are subject to taxation, understanding the “kiddie tax” rules can help you legally minimize or even eliminate taxes on the income they generate.
The Kiddie Tax: What You Need to Know
The “kiddie tax” applies to unearned income—like dividends or capital gains—that a child earns. Here’s how it works:
- First $1,300 of unearned income: Tax-free.
- Next $1,300: Taxed at the child’s tax rate, which is typically very low.
- Anything over $2,600: Taxed at the parents’ highest marginal tax rate.
These rules apply to children under 18 and full-time students between 18 and 24. Armed with this knowledge, you can structure a custodial account strategy to stay within these limits and generate tax-free growth.
Turning a Custodial Account into a Tax-Free Vehicle
Let’s say you open a custodial brokerage account and invest $5,000 in stocks. Over time, your investment grows to $6,000, leaving you with a $1,000 unrealized capital gain.
Most people would hold the stock, letting it grow further. However, by intentionally realizing gains each year, you can take advantage of the tax-free thresholds.
Here’s how it works:
- Sell the stock to lock in the $1,000 gain.
- Reinvest the proceeds in new investments.
Since the first $1,300 of unearned income is tax-free, that $1,000 capital gain will incur no tax liability. By repeating this process annually, you reset the cost basis and allow your child’s wealth to grow completely tax-free.
Customizing This Strategy for Your Family
Here are some ways to enhance this approach based on your financial goals:
1. Pair It with a 529 Plan
Many parents are comfortable using a 529 plan but don’t want all their savings locked into education-only expenses. By splitting contributions between a 529 and a custodial account, you gain flexibility. Use the 529 for tax-free growth on education expenses and the custodial account for future needs like a home down payment or starting a business.
Bonus Tip: Thanks to recent changes, you can roll over up to $35,000 from a 529 to a Roth IRA for your child under certain conditions.
2. Gift Appreciated Stock
If you hold highly appreciated stock in your portfolio, consider gifting it to your child’s custodial account. When your child sells the stock, they benefit from the lower tax rates (or no taxes at all) on the capital gains.
Example: A $1,300 gain in your custodial account could be tax-free, whereas the same gain in your portfolio could trigger taxes as high as 23.8%, plus state taxes.
3. Understand the Irrevocable Gift Rule
Once money is placed in a custodial account, it legally belongs to the child. They gain full control at the age of majority (18 or 21 in most states).
While rare, issues can arise if the child isn’t ready to manage the funds responsibly. If this concern resonates with you, consider alternative structures like trusts for larger sums.
Build Wealth Strategically
Custodial brokerage accounts provide an incredible opportunity to build wealth for your kids, but they require careful planning. By leveraging the kiddie tax rules and intentionally realizing gains each year, you can turn these accounts into tax-free growth engines.
If you’re ready to craft a customized plan for your family’s financial future, set up a complimentary discovery call with our team today.
This information is general education only and is not to be construed as specific tax, legal or investment advice.
