A custodial account for a child can be a good supplement to a 529 plan as long as you understand the pros and cons.
There are tax and financial aid implications to be aware of as well as the issue of control.
Using a custodial account to teach kids about saving and investing can make it even more valuable.
Each of our grandchildren has a 529 account, but in addition we'd like to provide more readily available cash. We plan to contribute on a quarterly basis and want to encourage them to contribute as well. Is a custodial account a good idea?
First, I'm happy to hear that your grandchildren have 529 accounts. As I talked about in a recent column, a 529 plan is one of the most effective ways to save for college. The fact that earnings grow federally tax-deferred and there's no tax on withdrawals used for qualified education expenses is a real plus. But with that covered, I can understand your desire to supplement their college funds with an additional source of cash. And I like the fact that you want to get them involved in saving.
A custodial account can certainly be a good choice for this type of extra savings, and a good way to teach the kids about investing. But as with anything, there are pros and cons. Here are some things to consider before you open the accounts.
You're in control—for a while
A custodial account is basically an investment account that you would set up in each of your grandchildren's names. Money deposited in the account immediately becomes the property of the child, so once it's done, you can't change your mind.
As long as the kids are minors, you would control the account and be responsible for managing and investing it appropriately. However, when they reach the "age of majority" (usually 18 or 21 depending on your state’s laws), they attain sole control of the money.
On the plus side, there are few restrictions on how the money can be used as long as it's for the benefit of the child (and not for the benefit of the family in general or for everyday living expenses). In other words, it can be used for things like summer camp, music lessons, a school trip, or even a first car.
On the minus side, once the grandkids are of age, you no longer have control of the assets. They can use the money however they wish. So while your intention may be to supplement their college cash or provide another enriching experience, there's no guarantee they won't blow the money on something frivolous.
There are tax and financial aid considerations
Beyond the issue of who controls the account, there are a couple of other things to be aware of in terms of taxes and potential financial aid:
- Gift tax limits—While there are no contribution limits for a custodial account, gift tax rules apply. In 2018, you can contribute up to $15,000 ($30,000 per couple) to a custodial account without being subject to a gift tax or even having to report the gift. Contributions above those limits won't necessarily trigger a gift tax, but you would be required to file a gift tax return.
- Taxation and new “kiddie tax” rules—There are some tax advantages in a custodial account. If your grandchildren are minors, the so-called “kiddie tax” rules apply. Portions of these rules were changed with the new tax law. As with the old law, in 2018 the first $2,100 in investment income is subject to be taxed at a modest rate or not at all. However, while in the past earnings above that initial limit were taxed at the parent's tax rate, with the new tax law, unearned income for minors above $2,100 will be taxed at rates that apply to trusts and estates. These rates range from 0-37 percent depending on the amount (and type) of earnings, which may be more or less advantageous to you. You should discuss this further with your tax advisor if you want more information.
- The impact on financial aid—When determining eligibility for federal financial aid under FAFSA, or the Free Application for Financial Aid, up to 20 percent of a child's assets are assumed available for college. Since assets in a custodial account belong to the child, you'll want to be aware of how this additional money in your grandchildren's name could affect financial aid opportunities down the road. If this is a big concern, it might make sense to consider other gifting strategies.
It can be a great teaching tool
If you do decide on a custodial account, it can be a great way to teach your grandchildren not only about saving, but also about investing. You might start by suggesting that they contribute a certain amount quarterly along with whatever amount you contribute. You can then show them how you're investing the money on their behalf.
By talking about the investment mix and types of assets, as well as showing them performance reports, you'll be teaching them investing basics and perhaps giving them a better awareness of the importance of good money management. Hopefully, that will set them on a positive path so that when they do have control of the account, they'll want to follow your good example and use the money wisely.
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