Custodial Savings Accounts for College
What are they?
Custodial savings accounts, which are governed by state laws known as the Uniform Gifts to Minors Act (UGMA) and the Uniform Transfers to Minors Act (UTMA), are the most popular types of savings accounts for minors. Most states have special laws about contracts entered into by minors, to the extent those are allowed: the minor can void the contract due to legal incapacity.
Due to that legal provision and other legal restrictions, minors can’t buy stocks, bonds, annuities, mutual funds, or life insurance policies without the assistance of an adult. If parents or guardians hold assets that they want to turn over to minor children, they can take advantage of various methods for transferring those assets. One such method is to establish a trust fund designated for the child, and a second, cheaper method is to use a custodial savings account.
Giving property to a minor through a custodial savings account avoids the expense of setting up and managing a traditional trust fund, because opening one does not require the help of a lawyer and incurs fewer legal obligations during the life of the account.
UGMA and UTMA accounts are very similar: both require a custodian, interested parties can donate any amount to either, and if the custodian dies before the child reaches majority, the accounts may be subject to estate tax. However, the UGMA and UTMA accounts accept different types of assets, which will help you choose between them.
UGMA Custodial Savings Accounts
The more limited UGMA account accepts only cash, securities and mutual funds, and insurance policies. In almost all states, UGMA has been superseded by UTMA because of that limitation.
UTMA Custodial Savings Accounts
The UTMA account allows for the donation of various assets, including stocks, mutual funds, bonds, annuities, life insurance policies, and other property like fine art, real estate, royalties, and patents. Of the two, the UTMA account is more flexible than the UGMA account.
How They Work
First of all, the donor of the account’s assets will need to appoint a custodian who manages the investments held in the account for the minor’s benefit. The donor will have to provide the Social Security number and name of the minor, and transfer those assets to the account. Once transferred, the donor cannot recover the assets.
They must remain in the account, or be spent for the direct benefit of the minor, until the minor reaches the age of legal majority. The status of those assets is simple: they belong to the minor, but they’re controlled by the custodian until majority (usually between 18-21, but varies from state to state).
One caveat: upon reaching legal age, everything in a custodial savings account belongs to the child outright. That means the child may dispose of it as he or she sees fit, and the child’s plan for spending may not include paying college expenses. That can make a custodial savings account a less-than-ideal vehicle for funding college.
Taxing of a UGMA or UTMA
Using a custodial savings account may also provide some tax relief to parents, because some of the income produced by those assets can be taxed at the child’s rate, which is usually lower, rather than that of the parents. Any investment income obtained from the trust (such as that from stocks, bonds, or annuities) will have to be reported on the minor’s tax return. The usual tax structure is this:
- The first $950 of investment income is exempt from tax
- The second $950 of investment income is taxed at the child’s rate
- Investment income over $1,900 is taxed at the parents’ rate.
The parent of the minor will be responsible for making sure the proper filing of the return takes place. The minor will need to sign his or her own tax returns starting at the age of 14.
A second caveat: contributing larger amounts may trigger gift tax, so make sure you know your tax code when making transfers. The current annual limit is $13,000, or $26,000 for contributions made jointly with a spouse.
What Can UGMA/UTMA Fund be Used for?
Remember that although UGMA and UTMA laws are very much alike from state to state (hence the word “Uniform” in their titles), you will need to check your state’s law to see what pre-majority expenses are considered appropriate. For example, that section of the North Carolina law that governs the use of property in a custodial savings account has a very broad standard that does not refer to any specific restrictions.
The account funds may not substitute for fulfilling any other financial obligation to support the child, however. That means the child’s parents must still pay for expenses like food, clothing, medical care, and shelter without using any of the money in the account.