One way to save for a child’s education is to use a custodial account. A custodial account is a savings account in your child’s name that you control until the child reaches age of majority. The age of majority is either age 18 or 21, depending on the state where the account is established.
This type of account is established through the Uniform Gift/Transfer to Minors Act. By law, a minor cannot own stocks or mutual funds, so in order for investments to be purchased in a minor’s name, custodial accounts must be used. The custodian on the account must use the assets in the account for the benefit of the minor. Once the child reaches the age of majority, the assets in the account become the sole possession of the child. The child can use the assets any way he or she sees fit. Earnings and capital gains are subject to kiddie tax in custodial accounts unlike assets in a 529 Plan account, Education Savings Account or Roth IRA account.
The first $950 of dividend interest income, etc. is income tax free. The next $950 is taxed at the child’s tax rate (10% for Federal tax). Anything over these amounts is taxed at the parent’s tax rate.
Advantages of Custodial Accounts:
- Financial Gifts
- The best use of a custodial account is when you want a minor to have ownership in stocks, bonds and mutual funds and see the compounding effect of interest.
- If the amount you are gifting is relatively modest, these accounts can be good vehicle.
- While unlimited contributions can be made to this type of account, you should keep in mind the gifting rules.
- The annual gift tax exclusion is $13,000 per person for 2011 ($26,000 if you are married). However, you can deposit as much money as you like into these accounts, and others can do so as well.
- Easy to Establish
- Accounts are easy to establish.
- Accounts can be opened at any bank or brokerage house.
- Taxed at parent’s tax rate for gains or income in excess of $1,800.
- The child gains control of the account when he or she reaches the age of majority, and the child could use the account for items other than educational expenses.
- A custodial account could reduce the chances of a child receiving financial aid. Under the current law, assets held in the child’s name count more heavily than parental assets when determining financial aid eligibility.
- The assets in a custodial account are only for the benefit of the child listed on the account. You cannot change the name (or beneficiary) of the account.
Other Item to Consider: Estate Tax Issue
If you are concerned about estate taxes, you should have someone else named as custodian of the account. Otherwise, if you die before the account terminates (child reaches age of majority), the account will be included in your estate, even if the gift has been transferred. It is included in your estate because you retained control of the assets for your child. This can be avoided by naming a custodian as someone who will not make gifts to the account.
If your goal is to have some assets accumulated before your children become adults, the custodial account is a good way to save.
If your primary goal is college savings, you should consider other types of accounts, such as 529 Plans or Education Savings Account. If you already have money in a custodial account for your child, you probably should continue to hold the assets in the custodial account rather than move the money to a 529 Plan. Moving assets from a custodial account to a 529 Plan may result in a gain, which you will have to pay tax on. You should consult with your financial adviser to make sure you are making the correct decision. For more information regarding this topic, please contact Henssler Financial at 770-429-9166 or [email protected].