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Saving for College: Custodial Accounts

Opening a college savings account is a smart way to invest in the education of a family member, a friend or even yourself—and 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. In this last installment of our three-part series, we’ll explore custodial accounts.

  • 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.
     

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 the age of majority—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 broad control how the money is invested and spent while your child is a minor. 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 the age of majority, the account reverts to her and she can use the money for anything she wants—college, a new car, a European vacation or something else entirely. Once your child is considered an adult by the state, you no longer have legal control over the account. However, many states may allow you to specify an earlier or later date to turn over the account’s assets to your child, as long as that date does not interfere with your state’s age of majority rules.

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 only limitation being that the funds must be used for 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.

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

 

Custodial account (UGMA/UTMA)

529 plan

Exempt from federal income  tax

Limited to first $1,050 of earnings

Qualified expenses for college, up to $10,000 for primary or secondary school tuition*

Investment options

Many

Limited

Income eligibility limit for contributors

None

None

Contribution limit

None†

Lifetime maximum (varies by state, generally $250,000-$500,000)

*Check with the 529 plan date rules to see if this option is permitted.  Not all states follow the new federal tax rules. You may be subject to state income tax and penalties for using 529 amounts for K-12 tuition expenses.

†Amounts over $15,000 per person ($30,000 for a married couple) in 2018 are subject to the gift tax.
 

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 $15,000 per year ($30,000 for a married couple) in 2018 without triggering the gift tax. 

The kiddie tax (for tax years prior to 2018)

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), which means the child will pay taxes at the trust tax rate over a certain threshold. In the past (tax years prior to 2018), the kiddie tax was based on the parents’ marginal tax rate. However, this was recently changed with the new tax law passed in December of last year.

How custodial accounts were taxed in 2017

Child under 19*
First $1,050 of unearned income is exempt from federal income tax
Next $1,050 of 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 were also taxed at their parents’ rate on unearned income in excess of $2,100 in 2017, unless the students’ earned income was greater than one-half of their support. Earned income from a job or self-employment isn’t subject to the kiddie tax.
 

The kiddie tax (for tax years 2018 to 2025)

Some of the changes made under the Tax Cuts and Jobs Act of 2018 impact custodial accounts. 

Most parents of children with modest unearned income from custodial accounts will pay the same or less taxes under the current kiddie tax rules, unless they have no taxable income. However, parents of children with significant unearned income from UGMAs/UTMAs may be faced with higher taxes because the parents’ tax rate is no longer used under the new law.

Instead, unearned income from custodial accounts over the threshold amount ($2,100 for 2018) will be taxed using the rates and brackets for trusts and estates.

How custodial accounts are taxed in 2018

Ordinary income Tax rates (2018-2025)
Up to $2,550 10%
$2,551 to $9,150 $255.00 +24%
$9,151 to $12,500 $1,839.00 +35%
>$12,501 $3,011.50 +37%


After 2025, the kiddie tax rates will revert back to the rules prior to 2018. Given the changing landscape of taxation on custodial accounts and income rates, it’s important to talk to a tax advisor about what might be the right approach for your situation. 

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 5.6% of the money to be available for college because they are 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 UGMA/UTMA proceeds into a 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 5.6% 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 UGMA/UTMA 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.

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. 

Consider your options

There are a number of resources for financial aid information, including the U.S. Department of Education and College Board. However, it’s always a good idea to check with your financial planner and a qualified tax advisor to determine which education savings route is best for you and your family.

What You Can Do Next

To discuss how this article might affect your investment decisions:

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.

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