Custodial Accounts Are Another Way to Save for College

There are many ways to save for college, from relatively recent products such as 529 plans to putting money away the old-fashioned way with U.S. Savings Bonds.

With both UGMAs
and UTMAs, there
are no contribution or
income limitations.

There's another option to consider: custodial accounts, which include Uniform Gift to Minors Act (UGMA) accounts and Uniform Transfer to Minors Act (UTMA) accounts. These accounts can be used to support a variety of financial objectives, one of which is as a tax-advantaged way to save for college. Here's what you need to know.

Who is the custodian? 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 (18 to 25, depending on the state in which you live). 

What are the tax advantages? In tax year 2018, for children younger than 19, or younger than 24 if a full-time student, the first $1,050 of unearned income is tax-free. The next $1,050 in unearned income is taxed at the child's federal tax rate, as is earned income over $1,050. Starting in 2018, pursuant to the Tax Cuts and Jobs Act, unearned income above $2,100 is taxed at the rates that apply to trusts and estates. Rates range from 10 percent for income up to $2,550, to a 37 percent rate for income above $12,501. To learn more about the tax rules for children, you should read IRS Publication 929: Tax Rules for Children and Dependents.

What investment options do they allow? 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. Furthermore, with both UGMAs and UTMAs, there are no contribution or income limitations. In addition, withdrawals can be used for any purpose, not just qualified education expenses, without penalty.

When does custody of the account end? When your child reaches the age of majority 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 want to explore other options, like a trust, where there is more flexibility to determine when control of the assets is given to a child or dependent. 

Are there any other downsides? Another potential disadvantage is that because the account is considered the child's asset, 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.

Anything else I should know? Yes. 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 you must also pay taxes on any gains you made on your investments. 

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