Good to Know
Custodial accounts are popular because they are easy to establish. A bank or brokerage firm can help your client fill out a simple form and have the account established almost immediately. Clients are also attracted to the contribution limits – there are no limits!
Before going farther, let us set a quick baseline – a custodial account is an account in which one party, the custodian, manages property such as investments on behalf of another party, the beneficiary.
- The custodian has a fiduciary responsibility to use account funds exclusively for the benefit of the beneficiary.
- Custodial accounts come in two basic flavors – the Uniform Transfers to Minors Act (UTMA) account and its predecessor in many states, the Uniform Gift to Minors Act (UGMA) account.
- The differences between custodial account types are subtle but important – when compared to an UGMA account, an UTMA account provides more liability protection to the custodian and has fewer restrictions upon assets that may be contributed.
Custodial accounts come with tax, control, and student aid caveats.
- Earnings from property owned by the custodial account are deemed “unearned income” by the IRS. Unearned income includes interest income, capital gains, and even passive income such as a limited partner’s allocated income from a partnership.
- There is no tax-deferral in a custodial account - unearned income is taxed in the year received at ordinary income tax rates, not capital gain rates.
- It gets worse - unearned income in excess of an annual limit ($2,200 in 2020) is taxed at the higher of the parent’s or the child’s marginal income tax rate.
- Any funds remaining in the custodial account are included in the custodian’s federal gross estate at his or her death.
Let us assume that the parent is named as the custodian of the account. That means that the parent can limit distributions to pay only college expenses, right? Regrettably, that turns out to be true only temporarily in some states. Depending upon the individual state in which the custodial account is established, the child gains control of the account as young as age 18 or as old as age 25. Once in control, the child can use custodial account funds to take an extended European vacation, buy a shiny new car or for whatever purpose that strikes the child’s fancy.
Student aid caveat
Assets held in a custodial account are considered the child’s asset for student aid purposes. That’s important because:
- Parentally-owned assets are considered available to pay for the student’s education expenses at a rate of only 5.64% or less (2020), but
- Assets owned by a dependent student are considered available to pay for the student’s education expenses at a rate of 20%.
For example, $100,000 in a 529 College Savings Plan owned by a parent would reduce student aid eligibility by a maximum of $5,640.00. That same $100,000 in a custodial account could reduce student aid by $20,000.00.
According to William Shakespeare, all that glitters is not gold. As far as saving for college is concerned, clients need to know that the glitter of a custodial account’s convenience should be filtered through the lens of powerful tax, control, and student aid caveats. For most clients, Section 529 College Savings Plans are only marginally more time-intensive to establish and have none of the caveats inherent to custodial accounts.