Smart Saving for College—Better Buy Degrees
Custodial accounts—Uniform Gift to Minors Act (UGMA) accounts or Uniform Transfer to Minors Act (UTMA) accounts—are another tax-advantaged way to save for college. A parent, grandparent or other adult is custodian for the account and makes all the investment decisions until the child for whom the account was opened reaches the age of majority. UGMA accounts are limited to money and securities. UTMA accounts can hold other types of property. You can set up these accounts at almost any brokerage firm, mutual fund company or other financial institution.
In tax year 2010, for children younger than 18, or younger than 24 if a full-time student, the first $950 of unearned income is tax-free. The next $950 is taxed at the child's federal tax rate. Any earnings over $1,900 are taxed at the custodian's federal tax rate. To learn more about the tax rules for children, you should read IRS Publication 929: Tax Rules for Children and Dependents.
As with Education Savings Accounts, your investing options are virtually limitless. And, there are no contribution or income limitations. Withdrawals can be used for any purpose, not just qualified education expenses, without penalty.
When your child reaches the age of majority—18 to 25 depending on the state in which you live—he or she takes control of the account and can use the money in the account for anything. Because you lose control over how the money may be spent, some parents and grandparents may not like this option.
Another potential disadvantage is that the account is considered the child's asset, so it may have a bigger negative impact on future financial aid. Plus, you can't switch beneficiaries. If your child decides not go to college or gets a scholarship, you can't switch the money to a brother, sister or other family member.
Tax-Free Transfer to a 529 Plan
You now can transfer funds from a custodial account to a 529 plan if the plan accepts such transfers. However, you must liquidate any investments you have made in a custodial account because you can only transfer cash and pay taxes, if any, on any gains. Another problem with transferring custodial account funds is that the money is the child's asset, not yours, so you cannot transfer the 529 plan to another beneficiary. There also may be other restrictions and limitations.
Download the print version:
FINRA Investor Podcast, Smart Saving for College—Part 1: 529 Plans
FINRA Investor Podcast, Smart Saving for College—Part 2: Other Tax-Advantaged Options