Saving for College: Custodial Accounts
March 28, 2013
Rande SpiegelmanCPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research
Custodial accounts—sometimes called 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 a certain age, usually 18 or 21 depending on the state of residence, the money becomes his or hers.
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.
Custodial accounts used to be the only tax-advantaged way to save for college. But lately they've been eclipsed by the tax-free benefits of 529 plans and Education Savings Accounts.
Still, custodial accounts have their place when you want to invest money 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 private voice lessons, for example—a custodial account may be just the thing.
Keep in mind that a custodial account is essentially an irrevocable 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.
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
Custodial accounts can't match the tax-free benefits of 529 plans or ESAs. Furthermore, the so-called "kiddie 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:
Tax Benefits of Custodial Accounts
| Child under 19* |
| First $1,000 of unearned income tax-free |
| Next $1,000 of unearned income taxed at child's tax rate |
| Any unearned income over $2,000 taxed at parents' tax rate |
*Full-time college students under the age of 24 are also taxed at their parents' rate on unearned income in excess of $2,000, unless the students' earned income is greater than one-half of their support.
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.
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.
Important Disclosures
Before investing, carefully consider the plan's investment objectives, risks, charges, and expenses. This information and more about the plan can be found in the Schwab 529 College Savings Plan Guide and Participation Agreement, available from Charles Schwab & Co., Inc., and should be read carefully before investing. If you are not a Kansas taxpayer, consider before investing 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 this plan. As with any investment, it is possible to lose money by investing in this plan.
The Schwab 529 College Savings Plan is available through Charles Schwab & Co., Inc. and is managed by American Century Investment Management, Inc. The plan was created by the Kansas State Legislature under the provisions of Section 529 of the Internal Revenue Code and is administered by Kansas State Treasurer Ron Estes. Notice: Accounts established under the Schwab 529 College Savings Plan and their earnings are neither insured nor guaranteed by the State of Kansas, the Kansas State Treasurer, American Century Investments®, or Charles Schwab & Co., Inc. Accounts established under the Schwab 529 College Savings Plan are domiciled at American Century Investments and not Schwab.
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.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. Each investor needs to review educational accounts based on his or her own particular situation.
The information is not intended, and should not be construed, as a specific recommendation, or legal, tax or investment advice, or a legal opinion. Individuals should contact their own professional tax advisors or other professionals to help answer questions about specific situations or needs prior to taking any action based upon this information.