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 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. In contrast, while 529 plans and Education Savings Accounts (ESAs) limit the tax advantages to education expenses, such accounts give you much more control over how they are used 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.
The table below shows how custodial account compare with 529 plans.
|Custodial account (UGMA/UTMA)||529 plan|
|Exempt from federal income tax||Limited to first $1,050 of earnings||Qualified expenses for college only|
|Income eligibility limit for contributors||None||None|
|Contribution limit||None*||Lifetime maximum (varies by state, generally $250,000-$500,000)|
*Amounts over $14,000 per person ($28,000 for a married couple) in 2017 are subject to gift tax. For 2018, the annual exclusion is $15,000 ($30,000 for a married couple).
Use your custodial account to invest for growth
Although past performance is no guarantee of future returns, stocks have historically 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 in a diversified portfolio that includes stocks. Then, gradually move those funds to more conservative holdings as your child nears college age.
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) in 2017 without triggering the gift tax. For 2018, the annual exclusion is $15,000 ($30,000 for a married couple).
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 (2017/2018)
|Child under 19*|
|First $1,050 of unearned income is exempt from federal income tax|
|Next $1,050of unearned income is taxed at child’s tax rate|
|Any unearned income over $2,100 is 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, federal financial aid formulas consider 20% of the money to be available to pay for college. Compare this to529 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 considered the owner’s assets and not the child’ (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. Every dollar saved is one dollar you may not have to borrow.
What you can do next
- Make sure that you’re considering the potential tax implications of your investments. Learn more about investment advice at Schwab.
- Talk to a financial professional. Find a Schwab Financial Consultant or visit a branch near you.
- If your tax situation is complicated, you may want to consult a tax professional.