Saving for College: Custodial Accounts

February 17, 2022
Custodial accounts may not offer the tax benefits of 529 plans, but they can be used to fund expenses that 529 plans don't cover.

A college savings account is a smart way to invest in the education for anyone, a daughter, nephew, grandchild—and it often comes with tax benefits.

There are multiple ways to save for higher education, and what works best for you depends on your (or your loved one's) personal needs and life goals.

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 can help.

  • The benefits: You can take advantage of the gift tax exclusion and control how the money is invested and spent for the benefit of the child, 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: the basics

Custodial accounts—also known as UGMA or UTMA accounts after the Uniform Gifts to Minors Act or Uniform Transfers to Minors Act that created them—are created for your child and managed by you. However, when your child reaches "termination age" —typically 18, 21 or 25 years depending on your state—the money automatically becomes his or hers.

The main benefits of a custodial account are that you can take advantage of the gift tax exclusion, and still have control over how the money is invested and spent while your child is a minor (as long as it is for their benefit). However, the exclusion requires the money to be an irrevocable "no strings attached" gift.

For example, 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 your daughter reaches termination age, the account reverts to her and she can use the money for anything she wants—college, a new car, a vacation, or something else entirely. However, some states may allow you to specify a later date to turn over the account's assets to your child, as long as that date follows state law.

In contrast, 529 plans and Coverdell Education Savings Accounts (ESAs) give you much more control over how the funds are used, including the ability to change beneficiaries as the need arises. The main limitation being that the funds must be used specifically for certain education expenses in order to receive tax advantages.

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 your child needs.

Custodial account

The table below shows how custodial accounts compare to 529 plans.

The table below shows how custodial accounts compare to 529 plans.

  • Custodial account (UGMA/UTMA)
  • 529 plan
  • Exempt from federal income tax
  • Custodial account (UGMA/UTMA)
    Non-taxable income is limited to the first $1,100 of earnings in 2021 and $1,150 in 2022
  • 529 plan
    Qualified expenses for college, up to $10,000 for primary or secondary school tuition1
  • Investment options
  • Custodial account (UGMA/UTMA)
    Many
  • 529 plan
    Limited
  • Income eligibility limit for contributors
  • Custodial account (UGMA/UTMA)
    None
  • 529 plan
    None
  • Contribution limit
  • Custodial account (UGMA/UTMA)
    None2
  • 529 plan
    Lifetime maximum (varies by state, generally $235,000-$550,000)

How to open and contribute to a custodial account

You can open a custodial account at virtually any brokerage or financial institution, and the minimum to open such an 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 $16,000 per year ($32,000 for a married couple) in 2022 without potentially triggering a gift tax. 

The kiddie tax

Unlike 529 plans and ESAs, custodial accounts are subject to the so-called "kiddie tax." This tax rule applies to unearned income (i.e., investment income) up to a certain threshold. Over that threshold, the child will pay taxes at the parent's tax rate.

How custodial accounts are taxed in 2021 and 2022

  • Child under 19 (2021)3
  • Child under 19 (2022)3
  • Child under 19 (2021)3
    First $1,100 of unearned income is exempt from federal income tax
  • Child under 19 (2022)3
    First $1,150 of unearned income is exempt from federal income tax
  • Child under 19 (2021)3
    Next $1,100 of unearned income is taxed at child's tax rate
  • Child under 19 (2022)3
    Next $1,150 of unearned income is taxed at child's tax rate
  • Child under 19 (2021)3
    Any unearned income over $2,200 is taxed at parents' tax rate
  • Child under 19 (2022)3
    Any unearned income over $2,300 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, federal financial aid formulas consider 20% of the money available to pay for college. Compare this to 529 plans, which are given more favorable treatment for financial aid. (The Free Application for Federal Student Aid (FAFSA) formula considers a maximum of 5.64% of the money to be available in a parent-owned 529 plan available for college because the money is considered the parent's assets and not the child's.)

While you can't roll over or directly transfer custodial account assets into a 529 account, you can cash out and reinvest the proceeds into a custodial 529 savings plan for the same minor. The benefit for doing so is that the UGMA/UTMA 529 account would still be considered a parent-owned asset and assessed at the 5.64% rate under FAFSA. Keep in mind that you'll be subject to pay taxes on any gains if you choose this option.

Additionally, not all 529 plans automatically allow for the transfer of funds from custodial accounts. Check to see if your 529 allows custodial account funds to be transferred. And remember, if you set up a custodial 529 account, the money can only be used for the same child specifically listed as the beneficiary of the UGMA/UTMA custodial account. You cannot rename the beneficiary and use the assets for another person.

The bottom line

Saving and investing for college is a wise 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 with interest. 

Learn more about saving for college.

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The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review educational accounts based on his or her own particular situation.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

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.

Investors should consider, before investing, whether the investor's or designated beneficiary's home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available in such state's qualified tuition program.

Investing involves risk, including loss of principal.

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