When it comes to saving money for your child, you have several options to choose from. Depending on what you are trying to accomplish will help you decide what option is the best for you.
- Do you want it to be solely used for college?
- Do you want the child to assume right to the money then they reach 18?
- Do you want tax deferral?
For parents that college isn’t the primary focus and they don’t mind if the kids gets control of the the money when they become a legal adult, then you may want to consider opening a custodial account under the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA). With these accounts, you appoint a custodian, which is typically the parent. Once the child reaches “age of majority”, then it’s legally their money and they get to do with it what ever they please.
Establishing UGMA and UTMA accounts means designating specific investments for a child’s benefit. By doing so, you may be able to reduce your estate and the taxes you owe on your investment earnings or capital gains. But these accounts also have certain drawbacks.
Where to Open a Custodial Account
Any financial institution typically allows you to open a custodial account. You just need the information for the custodian and the minor and make some sort of donation to open the account. One perk of the custodial account is that there is no ceiling on how much you can contribute or any income restrictions, unlike some of the other college savings plans.
One item that is important to truly comprehend is that any gift you make to your child is irrevocable, which means that once money has been given it is owned by the child and cannot be transferred back to the original owner. If you donate more than $13,000 in any year (as of 2010)—or $26,000 if you’re married and filing a joint return—to any one beneficiary you may have to file a gift tax return and eventually pay gift taxes.
Differences Between Custodial Accounts and 529 Plans or ESA’s
Unlike 529 plans and Education Savings Accounts, custodial accounts allow you to tap your money with ease. The general rule is that so long that the money is to be used for the child to benefit the child in some way and not the parent, it’s pretty much allowed to be purchased. For example, buying a car for your child when they reach 16 is perfectly allowed.
Tax Implications of Custodial Accounts: Kiddie Tax
One very BIG DIFFERENCE between UGMA and UTMA accounts vs. ESA’s or 529 Plans is how they are taxed. Custodial accounts are taxed as ordinary income, not tax free as they are in an ESA or 529 plan. This is what is called the Kiddie Tax.
Once your child turns 14, both the income and capital gains in the UGMA or UTMA account will be taxed at the child’s rate, which might be as low as 10% for interest income and 5% for qualifying dividends and long-term capital gains income, depending on your child’s total assets. Before your child turns 14, however, his or her earnings are taxed differently:
- The first $950 is tax free
- The second $950 is taxed at the child’s rate
- Any amount over $1,900 is taxed at the parent’s rate
This can be a tricky calculation especially if you have more than one kid. I definitely suggest seeking the counsel of a tax professional to assist you.
Pitfalls of Custodial Accounts
Paying less tax with custodial accounts might sound like a pretty good deal, but everything good thing usually has its price. Once your kids gains control of a custodial account, he or she is free to spend the money. The worst part is that they can spend it on whatever or whichever they want and you can do nothing about it. Visions of helping them pay for college could easily be erased with big ticket purchases such as new shiny car.
Federal Aid For College
Another thing to consider is that if you think your child will apply for federal aid when it’s time to attend college, a custodial account might not be the best option. Since UGMA and UTMA accounts are the property of your child, they may greatly affect chances of securing federal assistance. Students are expected to contribute the majority of their savings to their college educations in any year—as opposed to parents who are expected to contribute a much smaller percentage. If you have any more questions, you can head over the Finaid.org website.
Can You Transfer Money From a Custodial Account?
In certain cases, you may be able to move UGMA or UTMA assets into a 529 plan opened in your child’s name. But your transfers must be made in cash, which means you’ll have to liquidate the assets and pay capital gains taxes before moving the balance to a 529 plan. And since donations to an UGMA or UTMA account are considered gifts to the minor, the amount you transfer will still count as the minor’s assets, which will affect his or her chances of securing federal aid.
As you can see, there are many considerations that go into opening a custodial account. As of now, I’ve opened a custodial account just so I could buy some stock in certificate form for my oldest son. I bought the stock as more of a novelty than to save for his future. Most of our money that is to be saved for our kids future is currently going into a 529 plan and I don’t see that changing anytime soon.