Custodial Accounts
Before 529 plans and Coverdell ESAs, there were custodial accounts. A custodial account allows your child to hold assets — under the watchful eye of a designated custodian — that he or she ordinarily wouldn't be allowed to hold in his or her own name. The assets can then be used to pay for college or anything else that benefits your child (e.g., summer camp, braces, hockey lessons, a computer).
Here's how a custodial account works:
Application process. You fill out an application at Hocking Valley Financial Solutions and name a beneficiary.
Custodian. You also designate a custodian to manage and invest the account's assets. The custodian can be you, a friend, a relative or a financial institution. The assets in the account are controlled by the custodian.
Assets. You (or someone else) contribute assets to the account. The type of assets you can contribute depends on whether your state has enacted the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA). Examples of assets typically contributed are stocks, bonds, mutual funds, and real property.
Tax treatment. Earnings, interest and capital gains generated from assets in the account are taxed every year to your child. Assuming your child is in a lower tax bracket than you, you'll reap some tax savings compared with holding the assets in your name. But this opportunity is very limited because of special rules, called the "kiddie tax" rules, that apply when a child has unearned income. Under these rules, children are generally taxed at their parents' tax rate on any unearned income more than a certain amount. The “kiddie tax” rules apply to: (1) those under age 18, (2) those age 18 whose earned income doesn't exceed one-half of their support, and (3) those ages 19 to 23 who are full-time students and whose earned income doesn't exceed one-half of their support.
A custodial account provides the opportunity for some tax savings, but the “kiddie tax” sharply reduces the overall effectiveness of custodial accounts as a tax-advantaged college savings strategy. And there are other drawbacks. All gifts to a custodial account are irrevocable. Also, when your child reaches the age of majority (as defined by state law, typically 18 or 21), the account terminates and your child gains full control of all the assets in the account. Some children may not be able to handle this responsibility or might decide not to spend the money for college.
Related Links:
- 529 Plans
- Coverdell Accounts
- U.S. Savings Bonds
- Best Ways to Save for College
- Saving for Retirement and College at the Same Time
- Financial Aid Impact