Custodial accounts are a great way to save for a minor child's future, especially college. Although funds in a custodial account are not tax-deferred, the tax rate is based on the child rather than the adult custodian. As a result, taxes that must be paid on both earnings and withdrawals are substantially less.
Types of Custodial Accounts
Depending on your state of residence, custodial accounts may be either a Uniform Gift to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA). With custodial accounts, the child owns the funds while the adult custodian manages the money on behalf of the child until he reaches legal termination age, which is either 18 or 21. At that time, the child takes control of the account.
Custodial accounts are not tax-deferred. This means the account earnings are taxed. However, the tax rate is based on the child's lower tax rate rather than that of the adult custodian. In addition, funds up to a certain amount may be transferred into the custodian account without triggering a gift tax. For example, as of 2013, a single person could transfer up to $14,000 into the account per year or $28,000 per married couple without incurring gift taxes.
Effect of Withdrawal on Taxes
Withdrawals from the custodian account must be for the benefit of the child. The money can be used for any purpose, including school, and may be made as often as necessary. Like earnings, withdrawals from the account are taxed at the child's tax rate.
Parents often use custodial accounts to save for their children's college costs. However, the funds in custodial accounts are treated as the student's income. As such, the student's financial aid award may be lowered to offset these funds, and the reduction can be as much as 35 percent.
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