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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 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
Investment options Many Limited
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).

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 (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

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.

For more about financial aid, check out U.S. Dept. of Education or the College Board.

What you can do next

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.

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.

Investing involves risk, including loss of principal.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixedincome investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower rated securities are subject to greater credit risk, default risk, and liquidity risk.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.


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