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Custodial accounts, Part Two

Chris Farrell Nov 17, 2010

Question: Hi Chris, I went through all the questions in your blog about saving for college. You mentioned several times about 529. I have not heard your comment on custodial account. From what I heard, it has the same tax benefits but you can use it before college. Is it true? Thanks much. Saijai, Denver, CO

Answer: Thanks for checking out the questions and answers. The tax benefits on a custodial account aren’t anywhere near as generous as 529 college savings plan. That’s one reason why many parents have rolled over their children’s custodial accounts into the custodial versions of 529s.

I went into some detail about custodial accounts in yesterday’s post. You can check it out here. So, we’ll call this Part Two of the custodial account discussion, focusing on using an UTMA or an UGMA to save for your child’s college education.

Question: Hi Chris, I went through all the questions in your blog about saving for college. You mentioned several times about 529. I have not heard your comment on custodial account. From what I heard, it has the same tax benefits but you can use it before college. Is it true? Thanks much. Saijai, Denver, CO
There are three big advantages to 529 plans when it comes to saving for college. The savings compounds tax deferred. The earnings are tax free so long as it goes toward qualified educational expenses. The money is considered an asset of the parent for federal student aid purposes when the student is a dependent. (There are other benefits, but those are th three to highlight.)

Now, I want to dispose of one common criticism of custodial accounts. Parents often regret setting up one of these accounts as their child ages. They realize that it’s truly the child’s money. They may have set it aside for college, but their child may have a different idea, from buying a car to opening a restaurant to starting a social network. They get to decide what to do with the money.

However, in my experience the problem is exaggerated. Most students going to college are well aware of the steep price tag. They’re more than willing to contribute their share when it comes to paying the tuition tab.

The real benefit of a custodial account is its flexibility–the money doesn’t have to go for college. The advantages of a 529 plan evaporate if the money isn’t spent on higher education.

A drawback to a custodial account compared to a 529 is that the unearned inome in the custodial acount is taxed. The “Kiddie tax,” requires a portion of a child’s unearned income to be taxed at the parents’ marginal rate. The Kiddie tax has also been expanded to apply to full-time students under the age of 24 whose earned income does not represent at least one-half of their support, according to the accountants at Grant Thornton LLP. “Be careful transferring income-producing assets to your kids,” the accountants warn.

When it comes to financial aid, custodial accounts are treated as an asset of the student. It can have a bigger impact on financial aid packages than a 529. The custodial account is assessed at the student’s rate of 20% compared to the 5.6% rate on parental assets. When the savings or investment in the custodial account are cashed in to pay for college expenses the withdrawals aren’t tax free.

Yes, the parent custodian can spend the money in the account for the benefit of the child, but these expenses can’t be considered parental obligations. The standard advice–and its good advice–is to check with an accountant before touching the account.

These factors explain why parents often decide to rollover their children’s custodial accounts into a custodial version of a 529. It’s still the child’s money, but it’s now a tax-advantaged college savings plan. You can get a good description of the trade-off at Finaid.org: I also like Joseph Hurley’s savingforcollege.com website. It carries a basic article on what to consider when thinking about turning a regular custodial account into a custodial 529.

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