Custodial Accounts

Are you beginning to think about how you will finance your child’s education?  Or, are you a student whose parents are talking about college expenses and how they will pay them?  Many people think that custodial accounts are just for the rich.  That’s definitely not the case.  In fact, custodial accounts may be a great way for you to save for your child’s college education at any income level.  Keep reading to learn more about how custodial accounts work.

What is a Custodial Account?

In very basic terms, a custodial account is a savings account in your child's name that you control until your child reaches legal adulthood, either 18 or 21 depending on where you live.  You decide how much to put into the account, how the money is invested, how earnings are reinvested, and when to take money out of the account to spend on your child's behalf.

And a custodial account is flexible. You can deposit cash, savings bonds, and other securities into your child’s custodial account. The first $850 of earnings each year is tax free, and the next $850 is taxed annually at your child's rate — generally 15 percent. So you get tax breaks for setting up a custodial account.  Any earnings beyond that are taxed at your rate. Withdrawals are subject to federal tax as well. 

Advantages of a Custodial Account

Custodial accounts can be a great option for you.  There are a couple of advantages to having one.  They are very easy to set up.  A simple custodial account is as easy to set up as a savings account; you can do it at your local bank. If you intend to transfer a wide variety of investments, call a brokerage firm or your financial planner. They can help with the details.

Custodial accounts only have a few restrictions unlike many other saving vehicles.  You can deposit as much money as you want into a custodial account.  Although amounts over $12,000 are subject to the gift tax, so keep that in mind.  And other family members, such as grandparents, can do the same. You also can make withdrawals at any time — for your child's benefit — without paying penalties.

Disadvantages of a Custodial Account

Custodial accounts do have a few drawbacks that you should consider before choosing to set up one.  Custodial accounts are taxed heavily.  Earnings in a custodial account are taxed annually, as well as when you make a withdrawal.   And, your child has complete control of the money as an adult!   When you set up the account, you cannot dictate how the child will use the money once he or she is an adult.  Your son and daughter can use the money however they please at that point.

And, once you’ve set up your beneficiaries, you cannot switch them.  You cannot change the beneficiary to another child or to yourself.  So, that can be limiting if you determine later that you need to make a change.

If the advantages outweigh the disadvantages of having a custodial account, they are pretty easy to set up.  You can simply go to your local bank or any brokerage firm and quickly open a custodial account.  You’ll be on your way to saving for your child’s college education.