Another Kind of Childcare

As your family planning begins, Jaime Zimmerman suggests opening a custodial account to protect your future child’s financial health.

As your family planning begins, Jaime Zimmerman suggests opening a custodial account to protect your future child’s financial health.

One of the basic rules of smart investing is to start early. And when it comes to saving for your child’s education, the earlier you start, the better. By setting up a custodial account, in which you or another adult is the custodian of a child’s investments, you can save for future college costs or accumulate enough resources to give the child the funds with which to set out in life as an adult. It’s a great tool for parents, grandparents or others to make gifts of cash or securities to children who are too young to handle such assets.

A custodial account is simple to open, but you should consider whether an UGMA (Uniform Gift to Minors Act) or UTMA (Uniform Transfer to Minors Act) account is the best choice. In either case, it’s important to understand that the property held in a custodial account is owned by the child. In other words, once the gift is made, you can’t take the money back. Once more, when the child turns 18 or 21 (depending on the state’s age of majority), they can use the money for anything they want. We sometimes call these the “Yale or Vail” accounts.

Another concern of gifting assets to your child is that income generated may be subject to the “kiddie tax.” If the child is under age 18 and has unearned income above a threshold of $1,700 (2007), that income will be taxed at the parent’s rate, not the child’s. In addition, the money in the account may count against the child when seeking financial aid for college. And if you’re concerned about your own estate taxes, then you should avoid naming yourself as the custodian. If you die before the account terminates, the account will be included in your estate for tax purposes.

So what are the advantages of custodial accounts? For starters, although there are no contribution limits to a custodial account, anyone can transfer up to $12,000 without federal gift-tax consequences and you can transfer cash and/or securities into their account. For some, this is a great estate-planning tool. Transferring a highly appreciated stock avoids a tax consequence for you especially if the custodial account will likely pay a much lower rate of tax when the security is sold. Remember though, that YOUR cost basis of a gifted security carries over to the child and will be used to determine the amount of gain for tax purposes.

Other benefits of the UGMA or UTMA are that you as custodian have control of the assets as long as the child’s a minor. And withdrawals are not restricted to higher-education uses either. Unlike some other options, you can use the money as needed as long as it benefits the child.

Before establishing a custodial account, you should determine if other options may be more appropriate. You may find it would be better to invest in a Coverdell ESA, a 529 plan or a trust. It’s also possible a traditional IRA or Roth IRA may be more appropriate. As always, consult with your tax and financial advisers to see what’s most appropriate for your situation.