Saving for College: What Parents, Students Need to Know About Custodial Accounts

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Saving money for college in a weak economy can seem insurmountable, especially with rising tuition costs.

Students and their families have a plethora of savings options, including custodial accounts, which include a Uniform Gift to Minors Act account (UGMA) or a Uniform Transfer to Minors Act account (UTMA), invested in a bank or brokerage firm.

A UGMA custodial account is a simple way of transferring securities to a minor without the need for an attorney to prepare trust documents or for the court to appoint a trustee, according to FinAid.org. The terms of these accounts are determined by a state statute.

A UTMA custodial account is similar, but tends to be a little more flexible than a UGMA account. Along with CDs, stocks, bonds, and mutual funds that UGMA accounts usually invest in, minors can also own real estate, art, patents, and royalties with a UTMA.

Before the child reaches the age of majority or termination, which varies by state, the first $950 of unearned income is tax free, the second $950 of unearned income is taxed at the child’s tax rate, and any amount over $1,900 is taxed at the parent’s rate.

Once the child reaches the age of majority, the custodian managing the account transfers control of the funds to the child and any additional unearned income for the child is taxed at the parent’s rate under the “kiddie tax” rules.

“When these Gifts and Transfers to Minors Acts were initially set up, they were sort of ways for families to save money for their kid’s college, but what they were in actuality was a way to transfer wealth and tax attributes from high margin tax payers to lower margin tax payers,” says Margaret Munro, author of 529 and Other College Savings Plans for Dummies.

Munro points out that before the child comes into control of the account, parents are required to file a separate tax return for that child.

“You as the parent, up until the child is age 14, are to file a tax return on behalf of the child,” she says. “When the child is 14, they are old enough to sign his or her own return and then the requirement falls on the child to make sure that return is filed,” she says.

Advantages of a custodial account

Setting up a custodial account for a child may make sense for a high-income family looking to transfer wealth at a lower tax margin, according to Jeff Rose, certified financial planner and author of the blog Good Financial Cents.

“[For] someone who’s in the highest tax bracket to be able to gift away $13,000 or so for however many years, that can have a pretty substantial tax savings for that person,” he says.

Unlike a 529 college savings plan, where the money must be designated for educational purposes, the beneficiary of a custodial account can use the funds for whatever they choose to once they become of age .

“Prior to that, the custodian, who is typically the parent, can determine how to use that money for the benefit of the child,” says Joe Hurley, founder of SavingForCollege.com. “It’s actually probably an advantage rather than a drawback because if there are other needs that the parent wants to use that money towards, they can do that.”

Parents should be aware that even if the money is not used for school, it must be used in some way that benefits the child that does not fall under standard “parental obligations.” Things like a school trip to Europe, a new computer, or a few weeks at summer camp can be considered acceptable uses for the money, but parents should make sure to document any spending out of the account.

“You can always be asked by the IRS to provide proof that you actually spent it in this way on your child or on the custodial child,” says Munro. “That’s just good fiduciary practice, because the custodian has a fiduciary responsibility.”

Disadvantages of a custodial account

Although having the flexibility with the money in a custodial account can come in handy if your kid wants to use some of it on a big-ticket item, Munro cautions that once the child becomes of age, they may not choose to use it for college expenses.

“You’re handing a whole lot of money to somebody who has no idea how to handle it,” says Munro. “It doesn’t matter what your intent was, you could have labeled it the ‘UGMA college fund’, and [the kid] can do whatever he wants with it when he turns 18 and that’s a very big red flag for me.”

Unlike a 529 plan where if the child chooses not to go to school, you can transfer the money to another beneficiary for education purposes, UTMA and UGMA account beneficiaries cannot be changed; the custodian has given up all rights, titles, and interest of the property.

“It is a completed gift with the exception that if you die while the child is still a minor, the property is pulled back into your estate because you still as the custodian retain some control over it, but you cannot change who you are giving the gift to,” says Munro.

If financial aid is a concern for a family, having a custodial account in the child’s name can affect their eligibility.

“It counts as a student’s asset and therefore is assessed at a 20% rate in computing the Expected Family Contribution, which is a significantly higher rate than parent’s assets and a significantly higher rate than 529 plans, whether they’re owned by the student or the parent,” says Hurley.

While it is possible to liquidate a custodial account and transfer the funds to a 529 plan for the same beneficiary, Hurley explains that the minor will be taxed on any capital gain triggered as well as the impact that those capital gains could have on financial aid and income.

Should you decide to invest in an UGMA or UTMA account for your child, the experts recommend seeking the advice of a tax professional that is well-versed in the kiddie tax rules, which are adjusted annually and hard to track.