Custodial Accounts:

If parents want to transfer money or assets to their children to be used for college expenses, they may consider a custodial account such as UGMA (Uniform Gifts to Minors Act) or a UTMA (Uniform Transfer to Minors Act).

Custodial accounts provide some investment incentives and significant tax savings.

When you create a custodial account you are essentially gifting money or assets to a minor who can not legally own the funds. You become the custodian of the account until the child is 18 or 21 years old, depending on the state, at which time the child assumes control of the account

Advantages of UGMA and UTMA

One advantage of custodial accounts is that you may give up to $12,000 a year per child without paying gift taxes. Higher limits apply to married couples who contribute jointly. This represents a significant transfer of wealth over just a few years.

Another advantage is that earnings in a UGMA or UTMA account have some tax advantages. If the child is under 14 years of age, the first $750 earned in the custodial account is tax-free. The next $750 earned is taxed at the child’s tax rate.

This tax rate, usually around 10-15%, is the lowest. Higher earnings are taxed at your income rate. If the child is older than 14 years of age then all earnings are taxed at the child’s rate.

Disadvantages of UGMA and UTMA

There are some disadvantages of UGMA and UTMA that discourage many parents from using it as a college savings account. Because the child is the legal owner of the account, you may not transfer funds to another beneficiary.

Custodial accounts are also considered assets of the student; therefore funds in a custodial account can have a strong impact on financial aid eligibility.

A final disadvantage is that you lose control of the money when the child reaches maturity, either 18 or 21 years of age, which means although you intended the money to be spent on college expenses the child may decide to buy a new sports car instead.

Custodial accounts have some clear advantages as a savings tool for college, but most parents tend to find that the disadvantages outweigh the advantages.