UGMA/UTMA custodial accounts let children hold assets like stocks, bonds, and mutual funds in their own names–under the watchful eye of a designated custodian–that they legally wouldn’t be able to hold outright in their own names. Earnings, interest, and capital gains generated from assets in the account are taxed every year to the child. At one time, custodial accounts were a favored way for parents to save for their children’s college education due to the potential tax advantages of children being in a lower tax bracket than their parents. But in recent years, the tax savings associated with custodial accounts have steadily diminished as the kiddie tax rules have expanded.
The Kiddie Tax
The kiddie tax refers to special rules that apply when a child has annual unearned income over a certain amount ($1,800 in 2008). Unearned income is income other than wages or salary (for example, interest and investment earnings, and taxable gain resulting from the sale of an asset). Under the kiddie tax rules, a child’s unearned income over $1,800 is taxed at the parent’s (presumably higher) marginal tax rate.
The magic age for the kiddie tax used to be 14. Specifically, in the past, children under age 14 were subject to the kiddie tax rules, while children age 14 and older weren’t. So parents saving for college with a custodial account had a limited window of opportunity–after their children turned 14–when they could sell assets in a custodial account and not be subject to the kiddie tax.
But in 2006, the Tax Increase Prevention and Reconciliation Act raised the applicable kiddie tax age from under age 14 to under age 18. The result was that children under age 18 would now be taxed on their unearned income over a certain amount at their parent’s (presumably higher) marginal tax rate.
Then, in 2007, the Small Business and Work Opportunity Tax Act expanded the kiddie tax rules again, effective in 2008. Under these expanded rules, the kiddie tax now also applies to children who are under age 19, and to full-time students under age 24 (which covers traditional college students). There is an exception carved out for anyone in these two new categories who earns more than one-half of his or her own support.
The current kiddie tax rules are as follows:
Ramifications
The expanded kiddie tax rules significantly reduce the tax savings potential of custodial accounts, making them a less-than-stellar option for college savings. Now, if your child is a full-time student who does not earn more than one-half of his or her support, the kiddie tax rules will kick in if your child sells an investment asset (via the designated custodian) or has investment earnings before the year he or she reaches age 24.
Now what?
If you’ve been saving for your child’s or grandchild’s college education with an UGMA/UTMA custodial account, you may want to consider other options. One popular strategy that’s emerged in recent years is to transfer the assets in a custodial account to a 529 college savings plan.
However, be aware that the typical restrictions that are the hallmark of a custodial account (for example, a beneficiary who can’t be changed, gifts that can’t be revoked, money that can’t be withdrawn unless it’s used for the beneficiary’s benefit, and the requirement that all assets be handed over to the beneficiary when he or she reaches the age of majority, depending on state law) will be transferred onto the 529 plan. Your new account, referred to as a “custodial 529 plan” account, would be more restrictive than a 529 account you opened from scratch.
But keep in mind that you can only contribute cash to a 529 plan, so you’ll have to sell assets in your UGMA/UTMA to complete the transfer. This may result in capital gains that will be taxed to the child, potentially at the parent’s tax rate due to the kiddie tax.
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