Are Custodial Accounts a Good Option for Parents Saving for College?

Custodial savings accounts are getting a closer look from parents saving for college, with about 2 percent of parents using them to save for college. They work just like bank accounts, and anyone in (or out) of the family can contribute to custodial accounts for college, among other benefits. 

Recent changes in the tax treatment of custodial accounts have reduced the financial benefits of saving for college in a custodial account. However, custodial accounts can still be a valuable personal finance tool for savings beyond education and investing in a child’s future financial security.

What is a Custodial Account?

A custodial account, created with the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA), is established by an adult to benefit a minor child.

A custodial account for a child can be opened at most financial institutions – at a bank, a credit union, a brokerage firm or a mutual fund company, and all of the above on an online-only basis. State laws do apply, so age limits for custodial accounts can range from 18 to 21 (up to 24 for tax reasons), depending on the state where the account holder resides.

Because the account holder is legally considered a minor, that minor would need the approval of the custodian (usually an adult with the fiduciary responsibility to manage the account, such as the minor’s parent) to buy or sell investment-related securities.

After the custodial account is up and running, the account operates like most financial services accounts. The custodian makes investment decisions, and anyone, including family, friends, and other donors, can contribute to a custodial account.

When the minor who’s named in the custodial account reaches the legal age of majority in the state he or she resides (again, usually between 18 and 21), control of the account moves over from the custodian to the beneficiary, who can spend the account proceeds as he or she sees fit.

If the beneficiary decides not to go to college, and go travel the world with the fund assets, nobody can legally stop the beneficiary from doing so.

Types of Custodial Accounts

Typically, custodial accounts come in two forms – the Uniform Transfers to Minors Act (UTMA) and the Uniform Gift to Minors Act (UGMA.) The two are much alike, with one major discrepancy – legally, they each can only hold specific types of financial assets.

Here’s a breakdown:

• UTMA accounts. Parents and grandparents who may be the custodians should know what assets are allowed in each account. UTMA accounts have much greater flexibility and can act like investment accounts. They can hold most common investment-related types of assets, such as stocks, bonds, mutual funds, annuities and other insurance account assets. UTMA accounts can also hold alternative assets, such as real estate, jewelry, collectibles (like art of or even rare comic books), and intellectual property.
• UGMA accounts. UGMA accounts can only hold the most basic forms of investment vehicles – stocks, bonds, mutual funds and insurance-related investments.

UTMA accounts have superseded UGMA accounts in all states except South Carolina and Vermont.

It’s worth noting that no matter what type of custodial account you open, the financial services company running the account won’t allow the custodian to engage in the buying and selling of higher-risk investment vehicles, such as options, futures, commodities, and derivatives.

Buying and selling on margin, i.e., borrowing money to buy stocks, bonds, and funds, is also largely prohibited. Generally, a 529 college savings plan account has superior tax and financial aid advantages over an UTMA or UGMA account.

Tax Issues Related to Custodial Accounts

Custodial accounts previously provided significant tax savings for parents leveraging those accounts for college savings.

The primary tax benefits derived from custodial accounts came directly from Uncle Sam, as the Internal Revenue Service deems the minor as the owner of the account. Thus, any funds accumulated in the account were taxable at the minor’s tax rate.

In fact any minor under the age of 19, or under the age of 24 if he or she is a full-time college student, is allowed a specific amount of unearned income at a lower tax rate.

Recent changes in the U.S. tax code, as part of the Tax Cuts and Jobs Act of 2017, have diluted some of those tax savings, however.

Under the old federal tax structure (prior to 2018), any child under the age of 19 or any full-time college student under the age of 24, was allowed $1,050 in unearned income on an income tax-free basis. The next $1,050 was taxed at the minor’s federal tax bracket – the same went for any earned income above $1,050. Beyond this, the unearned income was taxed at the parent’s tax rate. This is known as the Kiddie Tax.

Starting in 2018, any unearned income in a custodial account above $2,100 is taxed at a much higher rate, at the tax rates that apply to trusts and estates. That could translate into taxes being levied on custodial account holdings at a 10% tax rate for income up to $2,550, but with tax rates quickly escalating all the way up to a 37% tax rate for income above $12,500.

Detailed information on tax rates for minors named in custodial accounts is discussed in IRS Publication 929, Tax Rules for Children and Dependents.

Pros and Cons of Using a Custodial Account for College Savings

Should a custodial account be used to save for college expenses? Like any financial account, the issue has its pros and cons.

Pros of Custodial Accounts

On the upside, custodial accounts geared towards college savings offer the following benefits:

There are no rules on how the money is spent

Cash saved in a custodial account can be spent not only on tuition and room and board, but also on laptop computers, smart phones, dorm room refrigerators and clothing for school. In short, anything purchase that benefits a minor is allowable in a custodial account. This is especially useful if the child decides to start a business instead of going to college.

No limits on how much you can invest

Anyone can contribute to a custodial account and for any amount of money they choose. There are no contribution limits. That said, federal gift taxes may add up the more a donor contributes to a custodial account, and should be factored into any custodial account contribution.

Investment options are plentiful

Either through an UTMA or UGMA account, custodial accounts can invest in stocks, bonds and mutual funds. UTMA accounts have a wider array of investment options, including real estate and collectibles.

Opening a custodial account is convenient

With banks and other financial institutions offering a storefront presence in most communities, it is easy to open an UTMA or UGMA.

Cons of Custodial Accounts

On the downside, custodial accounts can negatively impact college funding:

Limits on financial aid

Any financial assets established in a custodial account are a big “red flag” for colleges deliberating over financial aid to a student. Parental cash held in a state college 529 plan or an education savings account actually weighs less than a custodial account in a child’s name, when it comes to colleges awarding financial aid. Student assets in an UGMA or UTMA account reduce eligibility for need-based financial aid by 20% or 25% of the asset value, much more than the maximum 5.64% reduction for a 529 plan account that is owned by a dependent student or the student’s parent.

Better alternatives on taxes

529 college savings plans offer better tax advantages than a custodial account. Earnings in a 529 plan accumulate on a tax-deferred basis, and distributions are tax-free if used to pay for qualified higher education expenses.

No change in beneficiaries

You can’t change the account beneficiary with on an UGMA or UTMA account. You can change the beneficiary on a parent-owned 529 plan account, but not on a custodial 529 plan where the child is both account owner and beneficiary.

The Takeaway on Custodial Accounts

By and large, if you believe your child will require a significant amount of financial aid, a custodial account may not be a good move.

From a financial aid point of view, assets held in a minor’s name count more heavily against financial aid eligibility than do the parents’ assets or assets held in a 529 plan account. In fact, custodial bank and brokerage accounts can curb FAFSA-based financial aid by as much as 20%.

(You can roll UTMA or UGMA account assets into a custodial 529 plan and reduce the financial aid impact from 20% to 5.64%. Contributions to a 529 plan account must be made in cash, so you’ll need to sell the UTMA or UGMA account assets first. Spending down cash in a custodial account can also curtail the reduction financial aid in later college years.)

In addition, a custodial account doesn’t have the same tax advantages as a 529 plan account. 529s also offer parents more control, including the ability to change the account beneficiary.

That said, custodial accounts, like any accounts that contribute college savings, deserve close scrutiny to see if they can work for you.