Saving for College: Custodial Accounts

Custodial accounts may not offer the tax benefits of 529 plans, but they can be used to fund expenses that 529 plans don't cover.

 

If you want to set aside money for college expenses that aren't covered by an Education Savings Account (ESA) or 529 plan, a custodial account might help. 

• The benefits: You can take advantage of the gift tax exclusion to fund the account. You can control how the money is invested with many choices available to you while your child is still a minor. You also have flexibility in terms of how the money is spent as long as it's used for the benefit of the child. 
• The drawbacks: You can't change the beneficiary of a custodial account once it's established. Your child can use the money however they want after reaching a certain age, and investment income in custodial accounts may trigger the kiddie tax. The account can impact financial aid eligibility.

Saving for college

 

Custodial accounts: the basics

Custodial accounts—also known as UGMA or UTMA accounts after the Uniform Gifts to Minors Act or Uniform Transfers to Minors Act that created them—are typically established for a child and managed by a custodian, such as a parent. However, when the child reaches age 18, 21, or up to age 25, depending on the state of residence, legal control of the account automatically becomes theirs. 

For example, let's say a parent is managing a custodial account for their daughter. They may both agree that the money is for college expenses, but when the daughter turns 21, the account reverts to her and she can use the money for anything she wants—college, new car, vacation, or almost anything else. 

The main benefit of a custodial account is that parents can take advantage of the gift tax exclusion to fund the account while maintaining control over how the money is invested and spent while the child is a minor (as long as it's for their benefit). However, the exclusion requires that the money be an irrevocable "no strings attached" gift. 

In contrast, Coverdell ESAs give much greater control to the account owner, typically a parent, over how the funds are used, including the ability to change beneficiaries as the need arises. The main limitation being that the funds must be used specifically for certain education expenses to receive tax advantages. 

The key is knowing how and under which circumstances to use the various options. For example, custodial accounts can supplement a 529 plan or an ESA for a child's college education. If a parent wants to set aside money for college expenses that aren't covered by an ESA or 529 plan—sorority dues or car repairs, for example—a custodial account may be helpful.