Section 9.4 – Custodial Accounts & Education Savings Accounts

  • Accounts for Minors

  • Custodial Accounts (UTMA/UGMA)

  • Coverdell Education Savings Accounts (ESA)

1. Accounts for Minors:

  • Under securities law, minors are not considered “persons”, meaning:

    • They cannot open or manage a brokerage account.

    • They cannot make investment decisions on their own.

  • Instead, accounts for minors are managed by an adult (custodian) for the benefit of the minor.
    The two main types are:

    1. Custodial Accounts (UTMA/UGMA)

    2. Coverdell Education Savings Accounts (ESA)

2. Custodial Accounts (UTMA/UGMA):

  • A custodial account allows an adult (custodian) to manage investments for a minor (beneficial owner) until the minor reaches the age of majority.

  • Created under the Uniform Transfers to Minors Act (UTMA).

  • Assets are irrevocable gifts to the minor.

  • The custodian must act in the minor’s best interest (fiduciary duty).

Custodian’s Powers:

  • The custodian has full control of the account:

    • Can buy or sell securities, exercise rights/warrants, or liquidate holdings.

    • May use assets for the minor’s benefit, such as education, maintenance, or support.

    • Should not use funds for normal child-rearing expenses (like food or housing).

Rules & Restrictions

Rule / Description

  • Ownership / One custodian and one minor per account.

  • Custodian Eligibility / Must be an individual, not a corporation.

  • Multiple Accounts / A minor can have more than one custodial account; one person may act as custodian for multiple minors.

  • Application Requirements / Must include custodian’s name, minor’s name, minor’s SSN, and state. No court documentation required.

  • Taxation / Account uses minor’s SSN; taxes owed at the minor’s rate. Parent/guardian must ensure taxes are paid.

  • Cash Account Only / No margin trading or pledging securities as collateral.

  • Reinvestment / All cash, dividends, and interest must be reinvested within a reasonable time.

  • Investment Suitability / Must consider the minor’s age and risk tolerance. High-risk investments (futures, options, commodities) are inappropriate, except covered call writing, which is allowed.

  • Rights/Warrants / Must be exercised or sold—cannot be ignored.

  • Borrowing Rules / Custodian may loan money to the account, but cannot borrow from it.

  • Compensation / Custodian may be reimbursed for reasonable expenses. If the custodian is also the donor, no compensation is allowed beyond expense reimbursement.

  • Death of Minor / Account assets go to the minor’s estate, not the custodian or parent. A court appoints a new custodian.

Accounts

〰️

Accounts 〰️

3. Coverdell Education Savings Accounts (ESA)

  • Also known as an Education IRA.

  • Purpose

    • Designed to help pay for a child’s educational expenses using after-tax contributions.

Key Feature

Feature / Description

  • Contribution Limit / Up to $2,000 per student per year until age 18.

  • Income Phase-Out / Maximum contributions reduced or eliminated for high-income taxpayers.

  • Tax Treatment / - No tax deduction for contributions. - Earnings grow tax-deferred. - Withdrawals are tax-free if used for qualified education expenses.

  • Qualified Expenses / Includes college, secondary, and elementary school costs.

  • Nonqualified Distributions / Taxable plus 10% penalty on earnings.

  • Age Limits / - Contributions stop at age 18. - Account must be used by age 30, or the balance is distributed (subject to income tax + 10% penalty).

  • Rollover Option / Funds can be rolled into another ESA for a different beneficiary (such as a sibling) without taxes or penalties.

  • Popularity / Less common than Section 529 plans due to the low contribution limit.

Key Feature

Feature / Custodial (UTMA/UGMA) / Coverdell ESA

  • Purpose / General asset transfer to a minor / Education savings

  • Contribution Limit / No fixed dollar limit / $2,000 per year

  • Taxation / Taxed at minor’s rate / Tax-free for qualified use

  • Age Limit / Control transfers at age of majority / Must be used by age 30

  • Investment Control / Managed by custodian / Managed by adult for education purposes

Next Section

✺ Review questions ✺

  • A. They are not considered “persons.”
    B. They do not have income.
    C. They cannot pay taxes.
    D. They are subject to gift tax rules.

    ✅ Answer: A – Minors are not legal “persons” under securities law and cannot make investment decisions.

  • A. Multiple custodians and one minor
    B. One custodian and one minor
    C. A trust company as custodian
    D. Two minors and one custodian

    ✅ Answer: B – Each UTMA account must have one custodian and one minor.

  • A. Blue-chip stocks
    B. Mutual funds
    C. Covered call writing
    D. Commodity futures

    ✅ Answer: D – High-risk investments such as futures or options are inappropriate for minors’ accounts.

  • A. Reinvest dividends
    B. Loan money to the account
    C. Borrow from the account
    D. Use funds for the minor’s education

    ✅ Answer: C – Borrowing from the account is strictly prohibited.

  • A. Go to the custodian’s estate
    B. Are returned to the donor
    C. Pass to the minor’s estate
    D. Are transferred to the parent’s account

    ✅ Answer: C – The assets become part of the minor’s estate.

  • A. $500
    B. $1,000
    C. $2,000
    D. $5,000

    ✅ Answer: C – Up to $2,000 per year per student.

  • A. Real estate investment
    B. Qualified educational expenses
    C. Medical bills
    D. Charitable donations

    ✅ Answer: B – Only education-related expenses qualify for tax-free withdrawals.

  • A. 18
    B. 21
    C. 25
    D. 30

    ✅ Answer: D – Must be used by age 30 or distributed with taxes and penalties.