Custodial accounts are a common way for parents and grandparents to save or invest on behalf of a minor, but they often raise tax questions. The IRS generally treats the minor as the taxpayer but special rules, such as the kiddie tax and optional parent reporting, can complicate things.
A financial advisor can help you evaluate how a custodial account fits into your overall tax and financial strategy.
What Is a Custodial Account?
A custodial account is a financial account established for a minor and managed by an adult custodian. The assets in the account belong to the child, even though the custodian controls investment decisions and withdrawals until the child reaches the age of majority. This ownership structure plays a central role in determining who pays taxes on a custodial account.
Two laws, the Uniform Gifts to Minors Act (UGMA) and the Uniform Transfers to Minors Act (UTMA), govern the treatment of custodial accounts. These laws allow adults to transfer assets to minors without creating a trust. The specific rules, including the age when control transfers to the child, vary by state.
The custodian is responsible for managing the account in the minor’s interest, while the minor is the legal owner of the assets. This distinction explains why the IRS generally looks to the child, not the custodian, when determining tax liability.
Types of Income Earned in a Custodial Account
Because custodial accounts can invest assets a number of different ways they can generate several types of taxable income. The IRS taxes each type of income differently, which affects who pays taxes on a custodial account, and how much:
- Interest income: The IRS taxes the interest earned from savings accounts, bonds or CDs held in a custodial account in the year the account earns it. The custodian typically reports this income under the child’s name and Social Security number.
- Dividend income: Dividends from stocks or mutual funds are also taxable. Qualified dividends may receive lower rates, depending on the child’s overall income.
- Capital gains from investments: Capital gains occur on profits earned from selling assets. These gains may follow special tax rules, including the kiddie tax, if the income exceeds certain thresholds.
Who Pays Taxes on a Custodial Account?
Under IRS rules, the minor is generally responsible for paying taxes on income earned in a custodial account. Because the child legally owns the assets, the custodian reports the income under the child’s tax return. This is the default answer to who pays taxes on a custodial account.
The child’s tax rate often starts lower than an adult’s, which can create tax advantages for smaller amounts of income. However, additional rules limit these benefits to prevent income shifting from parents to children.
In certain situations, parents will report custodial account income on their own tax return. These situations depend on the amount and type of income earned, which we’ll cover further below, as well as elections made when filing.
When Parents Pay Taxes on a Custodial Account
Parents may elect to include a child’s custodial account income on their own tax return if it meets specific requirements. This option is typically available when the child has only interest and dividend income and that income falls below certain limits. Making this election can simplify filing, but may increase the parent’s tax liability.
There are limitations to this election. It cannot apply if the child earns income or capital gains above IRS thresholds. In addition, the election must occur annually and applies only to qualifying income.
There are limitations to this election. It cannot apply if the child earns income above IRS thresholds, including capital gain distributions from mutual funds, which are treated as dividends for this purpose.
The pros of reporting custodial income on a parent’s return include fewer tax filings and simpler administration. The cons include potentially higher taxes if the parent is in a higher tax bracket. Evaluating who pays taxes on a custodial account in these situations often involves weighing convenience against tax cost.
How the Kiddie Tax Affects Custodial Accounts
The kiddie tax is a set of rules designed to limit the tax benefit of shifting investment income to children. Under these rules, the IRS taxes a portion of a child’s unearned income at the parent’s marginal tax rate rather than the child’s rate. This directly affects who pays taxes on a custodial account when income exceeds certain thresholds.
Unearned income generally includes interest, dividends, and capital gains. Once income rises above the annual threshold, the excess may be subject to the kiddie tax. When the kiddie tax applies, the child still reports the income, but only a portion receives the parent’s tax rate.
The threshold is $2,700 for 2026 1 . Any income above that threshold is taxed at the parent’s rate. However, if the child earns less than $13,500 in interest and dividend income they can include it on their parent’s return.
How Custodial Account Taxes Change When a Child Comes of Age
When the child reaches the age of majority (typically 18 or 21, depending on state law), control of the custodial account transfers fully to the child. At that point, the former custodian no longer has authority over the assets. This transition does not change who pays taxes on a custodial account, but it does change who manages it.
After control transfers, the now-adult child is fully responsible for reporting income, paying taxes and making investment decisions. All income continues to be taxed under the child’s return, without parental involvement.
This shift can have long-term implications for the child’s financial life. Investment decisions made after the transfer may affect future tax brackets, eligibility for credits, and overall financial planning.
Strategies to Manage Taxes on a Custodial Account
Managing taxes on a custodial account often starts with thoughtful asset placement and investment selection. Choosing investments that generate lower current income, such as growth-oriented assets, may help limit taxable income during childhood. This can reduce exposure to higher tax rates and the kiddie tax.
Timing income and capital gains is another strategy. Deferring sales or realizing gains in years when income is lower may reduce taxes. Coordinating withdrawals and investment changes can help manage who pays taxes on a custodial account and at what rate.
You should coordinate any custodial accounts with your broader tax planning. This includes considering parents’ income, other savings vehicles and long-term goals. Professional guidance can help align custodial account strategies with the family’s overall financial plan.
Custodial Accounts vs. Other Child Savings Options
Custodial accounts are often compared with 529 plans, which are designed specifically for education savings. Unlike custodial accounts, 529 plans offer tax-deferred growth and tax-free withdrawals for qualified education expenses. These tax benefits can make 529 plans more attractive for education-focused goals.
Education savings accounts (ESAs) are another alternative. ESAs also offer tax-free growth for qualified education expenses but have lower contribution limits and income restrictions. Custodial accounts do not have these limitations but come with fewer tax advantages.
When comparing options, tax treatment is a key consideration. Custodial accounts offer flexibility in how funds are used but less favorable tax treatment. Understanding who pays taxes on a custodial account helps families choose the most appropriate savings vehicle.
Bottom Line
So, who pays taxes on a custodial account? In most cases, the minor who owns the account is responsible for taxes on the income it generates. However, parents may report some income, and the kiddie tax can shift higher amounts to a parent’s tax rate. Factors such as income type, thresholds, and the child’s age all influence how custodial account income is taxed.
Tax Planning Tips
- Because these rules can be complex, working with a financial advisor may help ensure custodial accounts are managed efficiently and aligned with broader financial goals. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you want to know how much your next tax refund or balance could be, SmartAsset’s tax return calculator can help you get an estimate.
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