Understanding Custodial Accounts

Establishing a custodial account can be a wise decision for parents who would liketo gift assets in order to help their children to save for future expenses and eventually become financially independent. There are details worth discussing so that parents fully understand the considerations and consequences in regards to utilizing custodial accounts.

Ownership

Funds that are transferred into a custodial account are considered an irrevocable gift to the minor and may only be used for expenditures that benefit that child. This means that funds within one child’s custodial account cannot be transferred to a sibling’s custodial account. Also note that the child will gain complete legal control over the account once they reach the age of majority recognized in your state of residence (usually 18 or 21 years old).

Taxation

The first $1,050 of the child’s investment income is generally tax-free. The next $1,050 is taxed at the child’s tax rate, which often is the lowest tax bracket of 10%. Investment earnings above $2,100 are taxed at the parent’s tax bracket until the child turns 19 (24 if the child is a full-time student). This tax is meant to discourage parents from reducing their own taxes by shifting investment income to their children and is often referred to as the “Kiddie Tax”. Note that state income taxes are also due where applicable and that the annual gift tax exclusion is $14,000 per year.

Impact on Financial Aid

When students apply for federal student aid a calculation is done to determine the expected family contribution. Within this calculation parental assets and income are assigned a lower weighting than student assets and income. Since custodial accounts are considered to be assets of the child and 529 College Savings Plans are considered to be assets of the account owner (typically the parent), college savings within a 529 College Savings account will have a smaller impact on financial aid eligibility than savings within a custodial account. See related blog post on 529 College Savings Plans.

Conclusion

While savings for a minor’s college education will in most cases be better suited within a 529 College Savings Plan, custodial accounts provide parents with a tax efficient way to accumulate wealth for their children to benefit from. Take for example a family that wishes to save in order to assist with their child’s first vehicle purchase. Instead of those funds being invested within the parent’s taxable investment account, which would be subject to the parent’s marginal tax rate; those funds could instead be gifted into the child’s custodial account, which would enjoy tax-free income for the first $1,050 per year and subject to the child’s tax rate for the next $1,050. These tax savings could remain invested within the custodial account hard at work accumulating wealth to be used for the child’s benefit.

Consider utilizing custodial accounts in achieving your family’s financial goals.