One of the ways that you can shelter some of your assets, and give your child a good financial head start, is to open a custodial account. A custodial account is one that you open in your child’s name, but that you control — at least until your child reaches the age of majority in the state the bank is based in. Established under the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA), a custodial account is a simpler alternative to a trust.
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Opening a Custodial Account
It’s important to note that a custodial account is different from a joint account. I have a joint savings account with my son; we are equally entitled to the money in that account. A custodial account, on the other hand, is one that belongs entirely to your child. You’re just supposed to manage until your child is 18 or 21 (depending on the state). Some of options for custodial accounts include:
- Savings accounts and CDs
- Investment accounts
If you want to save for college, it often makes more sense to open a 529 Plan account or a Coverdell ESA. The money grows tax free when used for qualified education expenses, and you might also receive a state income tax benefit, depending on where you live.
You can open a custodial account at most banks and brokerages, for example, CIT Bank offers this feature. You will need basic information about yourself and your child in order to open the account, as well as information about the bank from which you will fund the custodial account.
Things to Know about Custodial Accounts
Be aware that a custodial account is meant for your child. He or she owns the assets, and control reverts to him or her upon reaching the age of majority. Many parents open custodial accounts with the idea of getting some benefit, but don’t realize that — according to the law — they can’t just raid their child’s account whenever they want.
A custodial account can help you move assets around so that you can qualify for financial aid to go back to school. You can also use custodial accounts to reduce your own taxable income from investments. However, you aren’t supposed to just remove money as you wish. Once the money goes into the custodial account, it becomes your child’s. As the custodian, you are supposed to use the money for the child’s good, not withdraw it later when you want to.
Other things you should know about a custodial account:
- Your child could end up filing a tax return: If your child’s income exceeds $1,000 for tax year 2013, your child might need to file a tax return. You do have some different options if the entirety of your child’s income comes from interest, capital gains distributions from mutual funds, and dividends. You can include the income on your own tax return (and pay the tax).
- Watch out for the “kiddie tax“: That first $1,000 of your child’s income is tax-free. After that, your child is taxed at the youth rate for the next $1,000, which is currently set at 10%. Once your child gets beyond $2,000, he or she is taxed at your rate.
- Gift tax rules: Gift tax rules apply, even when you are moving money to your child’s custodial account. For 2013, you can add $14,000 to a custodial account without consequence. Your spouse can, too, for a total of $28,000. Once beyond that point, you need to file Form 709. You might not pay taxes, since there is a lifetime gift tax exclusion amount, but you still have to file the paperwork.
- Your child’s financial aid can be affected: Assets in a custodial account are considered your child’s so that money is taken into account when your kid applies for financial aid. This means that your child might not get the need-based aid that you would like.
Before you open a custodial for your child, make sure that you understand the realities of a custodial account. Do you trust your child to make good financial decisions at the age of 18 or 21 when he or she controls the assets?
Also, if you want your child to have a stockpile of cash that can be used for expenses other than education costs, it can help to start saving now. The money in a 529 or Coverdell is limited in use. What’s in the custodial account, though, can be used for anything.
Miranda is a professional personal finance journalist. She is a contributor for several personal finance web sites. Her work has been mentioned in and linked to from, USA Today, The Huffington Post, The San Francisco Chronicle, The New York Times, The Wall Street Journal, and other publications. She also has her own personal finance blog: Planting Money Seeds.