Monday, August 26, 2013

Custodial Account Basics

I can't link to the imamother threads that have inspired this informational post (I've seen a few posts in the past number of months), but I do hope that it will be of service because there is clearly a lot of confusion as to how the accounts are to be utilized and hopefully my quick post will be of service.  I happen to be a fan of custodial accounts, but one has to understand what a custodial account is and what the obligations of the parent is.

A very simple way to gift money to minors, as per federal statutes, and to take advantage of some tax saving strategies, is to place gifted moneyin a custodial account known more formally as Uniform Transfer to Minors Account (UTMA) or Uniform Gift to Minors Account  (UGMA) depending on your state of residence.

This is a simple, nearly paperwork free, way of gifting money, but unlike a trust account, they offer less protection of the funds as the gift giver relinquishes control of the account upon maturity of the minor (i.e. your 18 or 21 year old can blow it all on clothing the day they take control).  rusts offer more flexibility, protection, and control.  UTMA/UGMA accounts are pure, unrestricted gifts.

A custodian of the funds is assign, normally a parent, who can direct the funds and exercises discretion regarding any withdrawals which must be used "for the use and benefit" of the child.  They money should not be used for regular expenses or expenses that a parent is obligated to pay.  We have custodial accounts for all of our children and have yet to actually spend any of that money.  That said, if I were to make a withdrawal, my own standard would be 1) would rational and reasonable people believe that these expenses were for the child.  2)  Is there a good chance my own child will see these expenditures in years to come as being for his/her benefit?  Buying a textbook for a college math class my kid might take during high school:  acceptable.  Buying a simcha dress for an older sibling's wedding so everyone can match:  unacceptable.

These accounts must be transferred to the child at the age of 18 or 21, depending on the state of residence.  At that age, that money is the child's money. . . period.  You must turn these accounts over and your child will receive a 1099 under their own name and be responsible for the interest, dividends, and/or capital gains on the accounts.

The money, once deposited, is non-revocable.  In other words, you can't change your mind and take back the gift.  Nor can you proceed to use the gift for your own purposes because you had messed up your calculations when giving the gift.  Nor can you redistribute the funds from the custodial account of child A to the custodial accounts of children B, C, and D.  Even if the child passes on, you do not have the discretion to redistribute the funds.  The money is part of the child's estate and is distributed according to state law.

I happen to like custodial accounts for saving starter funds for children. It is a great way to save their birthday money and to gift them small amounts so they can get started when they are adults.  I don't believe they are a good way to save for college, although in the past parents used them, lacking other better alternatives.  A 529 offers far more control over college funds, as do Coverdell accounts.  This is not the way to save for a child's wedding, although I understand people have used them as such.  The adult and child's priorities may differ (perhaps for the good).  I do think they are a nice way to save a bit on taxes, but that tax savings comes with risk of the entire principal and earnings.  If you like control and want to exercise that control for years to come, this is not the account for you!

I hope this post will be of service to those considering custodial accounts or for those parents who have custodial accounts but simply don't understand the basics and the legalities.


Anonymous said...

Had a great-grandparent that was giving large gifts to by children on each birthday. We set up one of these accounts. Didn't feel right putting it in the college account (we see that as our responsibility), nor spending it on child related expenses (also our responsibility), so we put it in one of these accounts since my then small children lacked checking accounts.

We contemplated rolling it into the college savings accounts since things are tighter than we'd like. We've also thought about keeping them towards a car... the great-grandparent's health decline caused her to stop giving these gifts... had it gone a few more years, it would have been nice to know that a good used car would be available on their 16th birthday...

They are a weak vehicle for college savings, and silly one for wedding savings, but seem like a decent way to put baby through Bar Mitzvah gifts away for your child upon 18.

I mean, sure they could take the money saved over a lifetime of gifts and take a big trip to Europe or something... but isn't that the point of growing up, learning to make choices and suffer the consequences...

I mean, we're talking accounts that will likely have between $1k and $30k in them, it's not huge money... If they spend it wisely, it's a great head start in life, if they spend it poorly, they'll hopefully learn from what they gave up... I mean, they get control around the time they can sign for a 6 figure college loan, enlist in the armed forces, buy a first home, and get married... those are all MUCH bigger decisions than one of these small custodial accounts.

I agree that buying a dress for a sibling's wedding is a kind of lame use, since it's for the siblings benefit, not their own, but I don't think it would violate the tax code.

Orthonomics said...

Good comments. My comment about the dress was not that it does or does not violate legal regulations (it probably does not) but that a parent should not get in a situation where a child sues for an accounting. So basically use the money to save for the child. .. . not as a personal tax planning vehicle.

In the threads I do not point to, the issues faced are because the approach entering into the accounts was "let's tax plan" rather than "how can we save for the children in a tax-advantaged way."

As with my last point, the approach is important.

Anonymous said...

How is this account used for tax savings?

Orthonomics said...

If the child is younger than 18, the account earnings are not taxed for the first $950 in investment income. The next $950 is taxed at the child's rate. Any amounts over $1900 are taxed at the parent's rate.

This is a nice tax advantage, but not reason enough to set up money that the child will have full access to upon adulthood.

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