Saving for College: Custodial Accounts

Key Points

  • If you want to set aside money for college expenses that aren't covered by an Education Savings Account or 529 plan, a custodial account may be just the thing.
  • The benefits: you can take advantage of the gift tax exclusion and control how the money is invested and spent while your child is still a minor.
  • The drawbacks: Your child can use the money however he or she wants after reaching a certain age, and investment income in custodial accounts may trigger the kiddie tax.

Custodial accounts—also known as UGMA or UTMA accounts after the Uniform Gifts to Minors Act and Uniform Transfers to Minors Act that created them—are set up for your child and managed by you. When your child reaches the age of majority, typically 18 or 21 depending on your state, the money becomes his or hers.

The main benefits of a custodial account are that you can take advantage of the gift tax exclusion and control how the money is invested and spent while your child is a minor. However, the gift tax exclusion requires an irrevocable "no strings attached" gift to your child.

Let's say you're managing a custodial account for your daughter. You may both agree that the money should be used for college, but when she turns 18, 21 or 25 (depending on the state where she lives), she can use the money for anything she wants—college, a new car or a European vacation, for instance. Alternatively, while 529 plans and Education Savings Accounts (ESAs) limit the tax advantages to education expenses, you have much more control as the account owner, including the ability to change beneficiaries as the need arises.

With that said, a custodial account may still fit your needs under certain circumstances. Custodial accounts can supplement a 529 plan or an ESA for your child's college education. If you want to set aside money for college expenses that aren't covered by an ESA or 529 plan—sorority dues or car repairs, for example—a custodial account may be just the thing.

Use your custodial account to invest for growth

Although past performance is no guarantee of future returns, stocks have offered the best chance for money to grow over the long term—though stocks increase your chance for loss of principal compared to bonds or cash. If college is more than 10 years away for your child, consider investing primarily in stocks, either directly or via stock mutual funds and/or exchange-traded funds.

If you invest in mutual funds, consider investing in no-load funds to help minimize your fees and expenses—these can have a large impact on your return on investment.

How to open and contribute to a custodial account

You can open a custodial account at virtually any brokerage or financial institution. The minimum to open a custodial account typically ranges from $500 to $2,000.

Anyone (parents, grandparents, other relatives and friends) can make unlimited contributions to a custodial account once it's open. However, a person can't contribute more than $14,000 per year ($28,000 for a married couple) without triggering the gift tax.

Kiddie tax

Unlike 529 plans and ESAs, custodial accounts are subject to the so-called "kiddie tax." The tax rules apply to unearned income (i.e., investment income) which means the child will pay tax at the parents' rate on investment income over a certain threshold. 

How custodial accounts are taxed

Child under 19*
First $1,000 of unearned income is tax-free
Next $1,000 of unearned income is taxed at child's tax rate
Any unearned income over $2,000 is taxed at parents' tax rate

Effect on financial aid

Custodial accounts can have a heavy impact on financial aid. Because the money in a custodial account is your child's asset and not yours, financial aid formulas consider 20% of the money to be available to pay for college. Compare this to 529 plans, which are given more favorable treatment for financial aid—the formulas consider a maximum of 5.6% of the money to be available for college, because they are the owner's assets and not the child's (remember, the child is just the beneficiary).

Saving and investing for college is a smart financial move, even if you believe your child may qualify for financial aid. Remember, the majority of financial aid comes in the form of loans, which must be repaid.

For more about financial aid, check out FinAid.org or the College Board.

I hope this enhanced your understanding of custodial accounts. I welcome your feedback—clicking on the thumbs up or thumbs down icons at the bottom of the page will allow you to contribute your thoughts.

Next Steps

To put these strategies to work in your portfolio:
• Call Schwab anytime at 877-338-0192.
• Talk to a Schwab Financial Consultant at your local branch.

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Important Disclosures

Investment value will fluctuate, and shares, when redeemed, may be worth more or less than original cost.

As with any investment, it is possible to lose money by investing in a 529 Plan. Before investing, carefully consider the plan's investment objectives, risks, charges and expenses. Before making an investment decision, consider whether your or the beneficiary's home state offers a 529 Plan that provides its taxpayers with state tax and other benefits not available through certain plans.