Parents set up> custodial accounts for their children for various reasons but not always with the purest motives. Grandma gives $10,000 to little Freddie: Set up a custodial account. Parents want a tax shelter for little Jennifer s college savings fund: Set up a custodial account. A single mom wants to hide cash so she can qualify for financial aid and go back to school: Move the money into her kid s custodial account and take it back later. You get the idea. However, many parents fail to recognize that custodial accounts have significant legal and tax implications. Here are the five most important things to understand.
1. That Money Isn t Yours Anymore
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. Although the 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 themselves (like a new car). 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 other family members. And I ve never personally heard of a parent getting into legal hot water for raiding a custodial account. That said, staying on the right side of the law is the right thing to do.
2. Your Kid Will Gain Control at a Young Age
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). Remember: Nice little kids eventually turn into obnoxious teenagers, and young adults are not necessarily much better. So consider the possibility of future UGMA or UTMA regret before taking the irrevocable step of putting money into your child s custodial account.
3. Your Kid May Have to File Tax Returns and Pay Taxes
Any income from your child s custodial account belongs to the child. If that income exceeds $950, a separate federal income tax return generally must be filed for the child using Form 1040, 1040A, or 1040EZ. The child will probably owe some tax, and the kiddie tax rules may make it higher (see below). A state income tax return may be required too.
Exception: If all of your child s income consists of interest, dividends and mutual-fund capital gains distributions, you may qualify to simply include the income on your Form 1040 and pay the resulting extra tax with your return. For details on this simplifying option, see IRS Form 8814 (Parents Election to Report Child s Interest and Dividends).
4. The Kiddie Tax Might Bite
It would be swell if children with substantial custodial accounts were allowed to pay the same tax rates on investment income as other unmarried individuals. If that was allowed to happen, a child s 2010 ordinary income would typically be taxed at a federal rate of only 10% or 15%, and a 0% rate would typically apply to long-term gains and dividends. Unfortunately, the so-called kiddie tax prevents such happy outcomes. Under the kiddie tax rules, a minor child s investment income above $1,900 may be taxed at the parent s higher rates. So the federal rate on a child s interest income could be as high as 35%, and long-term gains and dividends could be taxed at 15%. The Kiddie Tax is calculated on IRS Form 8615 (Tax for Certain Children Who Have Investment Income of More Than $1,900) or on the aforementioned Form 8814 (when allowed).
Bottom Line: In the good old days, a custodial account could function as an efficient tax shelter because the income was taxed at the child s low rates. These days, the kiddie tax rules make it difficult for custodial accounts to deliver meaningful tax savings.
5. There Could Be Gift Tax Consequences
This year, you can take advantage of the annual federal gift tax exclusion to move up to $13,000 into a custodial account for each of your children. So can your spouse. You can do the same thing next year, and the year after that, and so on. Gifts up to the $13,000 annual limit don t reduce your lifetime $1 million federal gift tax exemption. However, if you transfer more than $13,000, you must file a gift tax return on IRS Form 709 (United States Gift (and Generation-Skipping Transfer) Tax Return). You probably won t actually owe any gift tax (thanks to the $1 million exemption), but you still have to file.
The Last Word
Custodial accounts are not as simple as advertised, and there s even more to the story than I ve told you here. For example, a healthy custodial account balance can reduce college financial aid awards. Check out www.fairmark.com/custacct/ for additional info.