IF YOU OPEN a regular investment account for your child, you need to set it up as a custodial account under your state’s Uniform Transfers to Minors Act or Uniform Gifts to Minors Act. With an UTMA or UGMA account, you typically name yourself as custodian. That means you call the shots on how the account is invested. The money you put in the account is an irrevocable gift to your kid. To fund the account, you might take advantage of the annual gift-tax exclusion, which means you could contribute as much as $15,000 in both 2019 and 2020 without worrying about the gift tax.
There are three big drawbacks with custodial accounts. First, while investment earnings in the account of up to $2,200 in 2019 and 2020 would be taxed at a modest rate, gains above that level could be taxed at a steeper rate, thanks to the so-called kiddie tax. That steeper rate used to be the parents’ tax rate. But in 2018 and later years, the rate is determined by the tax schedule that applies to trusts and estates, thanks to new rules introduced by the 2017 tax law.
Second, once your child reaches the age of majority, which is typically 18 to 21 depending on the state where you live, your kid can take control of the account—and the money could end up being spent on a fast car rather than a good education.
Third, in the financial aid formulas, a custodial account is considered a child’s asset, rather than a parental asset, which means it could cost you dearly in financial aid.
Our Humble Opinion: If you’re saving for a child’s college costs, a custodial account seems like a poor alternative to 529s and Coverdells, with their tax-free growth and favorable financial aid treatment. Got college money in a custodial account? You might move it to a 529, though that could trigger a big capital gains tax bill when you sell the custodial-account investments. What if you’re confident your family won’t qualify for financial aid and you want to invest for your child, so he or she will later have money for, say, a house down payment? In that scenario, a custodial account might make sense.
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