What are the potential tax implications of a custodial account?

Custodial accounts are a common way for families to save and invest for a minor child’s future, whether that’s for college expenses or a head start on a retirement fund. In fact, these accounts can offer greater flexibility than some other investment vehicles – like 529 plans or individual retirement accounts (IRAs) – but they come with tax rules that can easily be overlooked. Because the account legally belongs to the child, earnings are taxed in their name. Let’s look at how custodial accounts work and some tax considerations to help families avoid surprises at tax time.

Who owns a custodial account, and who reports the income?

Although a parent, guardian or adult family member – the custodian – manages a custodial account, the minor is the legal owner of the assets in the account. Under the Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA), the adult custodian has a fiduciary duty to manage the account in the child’s best interest.

The account is opened under the child’s Social Security number, so any investment income is reported in the child’s name. Brokerage firms issue Form 1099 each year to reflect the account’s interest, dividends and realized capital gains.

Contributions and gift tax rules

Contributions to a custodial account are considered irrevocable gifts, so once the assets are transferred, they legally belong to the child and cannot be taken back. Contributions are also not tax-deductible. However, they are governed by federal gift tax rules.

For 2026, individuals can give up to $19,000 per recipient without triggering gift tax reporting. (This is known as the annual exclusion amount.) If you or another adult contributes more than that amount to the same child in one year, a gift tax return must be filed to report the excess. In most cases, the excess over $19,000 counts toward the person's lifetime gift tax exemption of $15 million rather than triggering an immediate tax bill. The annual exclusion applies per person and per recipient, so relatives or family friends can also contribute up to the annual limit without affecting the other person’s annual exclusion. For example, in one year, you could gift up to $19,000 to your child and then your sister could also gift up to $19,000 to your child, for a total of $38,000.

If parents contribute more than $19,000 to their child’s custodial account, they may be required to file a gift tax return even if the combined amount isn’t more than $38,000 – it depends on where the money came from (a joint account or an individual account in the name of only one spouse, or whether the gift was made from community property or separate property).

How investment income is taxed each year

If a child’s unearned income exceeds certain IRS thresholds, they may need to file their own federal (and state) tax return. In some cases, a parent can elect to report a child’s interest and dividend income on their own return using Form 8814. This increases the parent’s adjusted gross income (AGI), however, and may affect their eligibility for tax credits or deductions. As a result, families may choose instead to file a separate tax return for their child.

Custodial accounts can generate several types of investment income, and each type is taxed differently:

Any realized gains or losses are reported on the child’s tax return. Losses can offset the child’s gains but cannot be used to reduce a parent’s taxable income.

Mutual funds and exchange-traded funds (ETFs) may also generate capital gains distributions, which are taxable in the year they’re paid even if no shares were sold. Because of this, it can be helpful to pay attention to distribution timing – buying into a mutual fund just before its annual distribution, for example, could leave your child owing taxes on gains they didn’t benefit from.

Families can sometimes reduce their taxes by holding tax-efficient investments like municipal bonds in taxable accounts like custodial accounts. But you shouldn’t necessarily let the tax tail wag the investment dog. Before buying municipal bonds for their tax advantages, consider whether and how they might fit in with your overall financial plan.

The ‘kiddie tax’: When a parent’s rate applies

The “kiddie tax” is designed to prevent parents from moving investment income to their children to take advantage of children’s generally lower tax rates. It applies to children under 18, as well as to full-time students under 24 whose earned income doesn’t cover more than half their own support.

For 2026, the first $1,350 of a child’s unearned income is tax-free, the next $1,350 is taxed at the child’s rate and any unearned income above $2,700 is taxed at the parent’s marginal rate – regardless of whether the income is reported on the child’s separate tax return or is included on the parents’ return. These thresholds are adjusted periodically, so it’s worth checking current IRS guidance when filing.

If the kiddie tax applies, the child typically files IRS Form 8615 (PDF)Opens overlay  with their tax return. This form calculates how much of the child’s income is taxed at the parent’s rate. Because of these rules, it’s important to keep taxes in mind as you create an investment strategy for the custodial account – but again, your investment goals, and not tax consequences, should be the primary driver of your strategy.

Cost basis, holding periods and recordkeeping

When assets are gifted to a child via a UGMA or UTMA custodial account, the child inherits the donor’s cost basis and holding period, which is known as a carryover basis. For example, if a grandparent gives shares of stock purchased for $5,000 that are now worth $9,000, the child’s basis remains $5,000. If the shares are sold, capital gains tax would apply to the $4,000 increase in value. In some cases, like when the asset’s value is lower than the donor’s basis at the time of the gift, special rules may apply.

Reinvested dividends can increase the child’s cost basis, so tracking reinvestments can help you avoid overpaying taxes when the assets are eventually sold. Brokerage statements and records of gifted assets can make future tax reporting much easier.

State taxes, surtaxes and special situations

Federal taxes aren’t the only consideration, since most states with an income tax also tax a child’s investment income. The exact rules vary by state, however.

Selling assets to cover expenses can generate taxable gains if the assets have appreciated. For example, if you move custodial assets into a 529 plan to take advantage of tax-free growth for education, these assets must first be sold, which could trigger capital gains taxes.

The resulting account is typically a custodial 529, meaning it remains the child’s asset and cannot be transferred to another beneficiary. When the child reaches the age of majority, they gain full control of the account and its future tax filings.

In cases involving very large accounts, or in some cases if the income from the custodial account is reported on the parents’ tax return, federal surtaxes like the net investment income tax (NIIT) may also apply.

The bottom line

Custodial accounts can be a useful way to invest on behalf of a child, but the tax rules are more complex than many families expect. Contributions are permanent gifts to the child, earnings are taxed in the child’s name and the kiddie tax can bring a parent’s tax rate into the picture. Understanding how custodial accounts are taxed can help you avoid surprises and make the most of these accounts’ long-term benefits. Your tax professional can help explain how these considerations impact you. A J.P. Morgan advisor can help create a custodial portfolio designed to help you reach your goals for your child.

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