What Type of Account to Open for a Baby?

Parents open financial accounts for their children to establish a foundation for future financial well-being. Early financial planning provides benefits, whether saving for higher education, a first car, or teaching financial literacy. These accounts allow assets to grow, potentially providing a substantial sum when the child reaches adulthood. Understanding the options is important for informed decisions.

Types of Accounts for Children

Several types of financial accounts cater to minors, each with distinct features. Custodial savings and investment accounts (UGMA or UTMA) are common choices. These accounts are managed by an adult custodian for a minor’s benefit, holding assets until the child reaches the age of majority (typically 18 to 21, depending on state). Money deposited is an irrevocable gift to the child, meaning it cannot be taken back.

Custodial savings accounts are like regular savings accounts, managed by an adult for a child. They offer a straightforward way to save cash for general purposes. Earnings may be subject to “kiddie tax” rules, where unearned income above certain thresholds is taxed at the parent’s rate. Contributions are subject to federal gift tax rules; individuals can contribute up to $19,000 annually per recipient in 2025 without gift tax implications.

Custodial investment accounts (UGMA and UTMA) allow for a broader range of assets beyond cash. UGMA accounts typically hold financial assets like stocks, bonds, and mutual funds, while UTMA accounts are more expansive, permitting real estate, art, and other tangible property. These accounts enable adults to invest on behalf of a minor, offering potential for greater asset growth. The custodian makes all investment decisions, but assets and accumulated earnings irrevocably belong to the child, who gains full control upon reaching the age of majority.

Education savings plans, such as 529 plans, help families save for qualified education expenses with tax advantages. Contributions are made with after-tax dollars, but earnings grow tax-deferred, and withdrawals are federal tax-free when used for eligible educational costs. Qualified expenses include college tuition, fees, books, room and board, and up to $10,000 per year for K-12 tuition. The account holder maintains control and can change the beneficiary to another eligible family member if needed.

The Coverdell Education Savings Account (ESA) is another education-focused option. Similar to 529 plans, Coverdell ESAs allow for tax-deferred growth and tax-free withdrawals for qualified education expenses. A key distinction is their broader definition of qualified K-12 expenses, which can include tuition, books, supplies, equipment, academic tutoring, transportation, and uniforms. Coverdell ESAs have a lower annual contribution limit of $2,000 per beneficiary per year, and contributions are subject to income limitations for the donor. Funds must be used by the time the beneficiary reaches age 30.

Choosing the Right Account

Selecting the appropriate account involves aligning financial goals with each account type’s features. If the primary objective is general savings or gifting assets for any future purpose, such as a down payment on a home, custodial accounts like UGMA/UTMA are suitable. These accounts offer flexibility in how funds can be used once the child gains control. If savings are intended for educational expenses, 529 plans or Coverdell ESAs provide more tax advantages.

Understanding who controls the money and when the child gains access is important. With UGMA/UTMA accounts, the custodian manages funds, but assets legally belong to the child from contribution, and the child gains full legal control at the state’s age of majority. This means the child can use the money for any purpose once transferred, which might not align with the donor’s original intent. In contrast, the account holder retains control of 529 plans indefinitely and can change the beneficiary.

Tax implications also play a role. Contributions to both custodial accounts and 529 plans are considered gifts and are subject to annual gift tax exclusion rules. The “kiddie tax” applies to unearned income in custodial accounts above certain thresholds, taxing investment earnings at the parent’s rate. Conversely, earnings within 529 plans and Coverdell ESAs grow tax-free, and withdrawals are tax-free if used for qualified education expenses. Non-qualified withdrawals from education savings plans are subject to income tax and a 10% penalty on the earnings portion.

The potential impact on financial aid eligibility for higher education is another factor. Assets held in parent-owned 529 plans have a minimal impact on financial aid calculations. Distributions from these plans for qualified expenses are not considered income on financial aid forms. However, funds in child-owned UGMA/UTMA accounts are assessed at a higher rate, 20%, significantly reducing potential need-based financial aid. Starting with the 2024-25 academic year, 529 plans owned by grandparents or other relatives no longer count as student income on the FAFSA.

Steps to Open a Child’s Account

Once the decision is made on the account type, gathering information and documents is the first step. For the child, this includes their full legal name, date of birth, and Social Security Number. A birth certificate may also be required as proof of age and relationship.

For the parent or guardian (account holder or custodian), a valid government-issued photo identification (e.g., driver’s license or passport) is essential. Proof of address (e.g., utility bill or bank statement) and Social Security Number are also necessary. Documentation requirements can vary between financial institutions.

Selecting a financial institution involves considering whether an online or traditional bank is preferred, account fees, and investment options for custodial investment accounts. Many online brokers and traditional banks offer custodial account options; comparing offerings ensures the best fit. Researching minimum deposit requirements and ongoing maintenance fees is a prudent step.

After selecting an institution, the application process can be completed online or in person. For certain accounts, both the parent and child may need to be present at a branch to complete the application. Forms require entering details for the child and the designated account holder or custodian. The final step involves funding the account, which usually requires an initial deposit, with options for setting up ongoing contributions.