Probably the most common reason that parents set up custodial accounts is to save for a child’s college in what they think is a tax-smart fashion. Or a custodial account might be set up to hold generous annual gifts to your child from good old Grandpa Henry. The potential problem: some parents fail to recognize that custodial accounts have significant tax and legal implications. This column explains the most important things to understand. Since I’m a tax guy, I’ll hit the tax issues first. But the legal issues are actually more important. So please read the whole thing.
You may have to file tax returns for your child
Any income from your child’s custodial account belongs to the child. If that income exceeds $1,100 for 2019 ($1,050 for 2018), a separate Form 1040 generally must be filed for your child, and he or she will probably owe some tax. The Kiddie Tax rules may make it higher (see below). Depending on where you live, a state income tax return may be required too.
The Kiddie Tax may bite
It would be swell if children with substantial custodial accounts were allowed to pay the same tax rates on investment income from the accounts as other unmarried individuals. If that was allowed to happen, your child’s 2019 interest income and short-term capital gains from a custodial account would typically be taxed at a federal rate of only 10% or 12%. Long-term capital gains and dividends would typically be taxed at a 0% federal rate. That would be nice.
Unfortunately, Congress created the so-called Kiddie Tax to prevent such happy outcomes. Under the Kiddie Tax rules, a minor child’s investment income above the annual threshold ($2,200 for 2019) can potentially be taxed at the rates that apply to trusts and estates. Those rates quickly rise to 37% on interest income and short-term gains and 20% on long-term gains and dividends. The sad conclusion is that the current Kiddie Tax rules make it difficult for custodial accounts to deliver any meaningful tax advantage.
Custodial accounts are not a no-brainer option for saving for college or giving your minor child a financial head start in life.
Note: Before the Tax Cuts and Jobs Act (TCJA), the Kiddie Tax rules could tax a child’s investment income above the annual threshold at the parent’s marginal federal rate. For 2018-2025, the TCJA changed the deal. The Kiddie Tax is now calculated using the using the same tax rates and brackets that trusts and estates must use. That change can produce a bigger Kiddie Tax bite than under the prior-law rules. For the full story on how the current Kiddie Tax rules work, see here.
You may have to file gift tax returns
For 2019, you as a parent can take advantage of the annual federal gift tax exclusion to move up to $15,000 into a custodial account for each of your children. If you are married, so can your spouse. You can do the same thing next year, and the year after that, and so on. Gifts up to the $15,000 annual limit (for 2019 and probably for the next several years) will not reduce your unified $11.4 million unified federal gift and estate tax exemption (for 2019).
However if you transfer more than $15,000, you must file a gift tax return on Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return. You almost certainly won’t actually owe any gift tax (thanks to the generous $11.4 million exemption), but you still must file a gift tax return. Rats.
That money belongs to the kid, not you (seriously)
When funds are transferred into a minor child’s custodial account at a financial institution or brokerage firm, the funds now irrevocably belong to that child. While a parent can, and usually does, function as the custodian (manager) of the account, the money can legally be used only for expenditures that benefit that child. In other words, parents are legally forbidden from using custodial account money for expenditures that benefit only themselves (like cosmetic surgery and an expensive new wardrobe).
And you can’t take money from one kid’s custodial account and use it to open up or supplement an account for another kid.
Obviously, it can be a fine line between expenditures that benefit the child and those that benefit you or other family members. Just understand that the funds in the custodial account are not yours to use any way you choose, even if you were the one who funded the account.
The kid will gain control at a young age (gasp)
A minor child’s custodial account must be established under your state’s Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA). Under applicable state law (most states have UTMA regimes these days), your child will gain full legal control over the account once he or she ceases to be a minor. This will happen somewhere between age 18 and 21 (in most states it’s 21).
Warning: Sweet little children can eventually turn into obnoxious teenagers, and young adults are sometimes not much better. So consider the possibility of future “UGMA or UTMA regret” before taking the irrevocable step of putting money into a child’s custodial account.
The bottom line
Custodial accounts are not a no-brainer option for saving for college or giving your minor child a financial head start in life. You might be better off keeping money that is eventually destined for your child in your own name or using a Section 529 plan to save for college. That way, you can avoid tax and legal complications that can come into play with custodial accounts. A good source for additional information on custodial accounts is here.
