How To Pay for College
- Paying for College
- Scholarships and Grants
- College Savings Plans
- Federal Student Loans
- Private Student Loans
- Financial Aid 101
How to Save with Custodial Accounts
Custodial accounts - Uniform Gift to Minors Act (UGMA) accounts or Uniform Transfer to Minors Act (UTMA) accounts - are another tax-advantaged way to save for college. A parent, grandparent, or other adult is custodian for the account and makes all the investment decisions until the child for whom the account was opened reaches the age of majority (18, 21, or 25 depending on the jurisdiction). You can save for college with custodial accounts by setting up an accounts with almost any brokerage firm, mutual-fund company , or other financial institution. Custodians can gift assets in addition to cash and securities, including real estate, fine art, antiques, patents, and royalties. You may use the custodial account to save for college or to benefit the child in any way, excluding parental obligations like food and shelter. If you have an UGMA/UTMA account, you can sell the assets and transfer the proceeds into a 529 plan or ESA of your choice.
Advantages of Custodial Accounts
For children younger than 14, the first $950 in earnings in a custodial account is tax-free. The next $950 in earnings is taxed at the child's federal tax rate. Any earnings over $1900 are taxed at the custodian's federal tax rate. For children over 14, the first $950 in earnings is still tax-free, and all earnings after that are taxed at the child's tax rate. To learn more about the tax rules for children, you should read IRS Publication 929: Tax Rules for Children and Dependents.
As with ESA's, your investing options are virtually limitless, there are no contribution or income limitations, anyone can contribute and there is no penalty for withdrawals used for qualified education expenses.
Disadvantages of Custodial Accounts
When your child reaches the age of majority, he or she takes over control of the account and can use the money in the account for anything. Some parents do not like this option because you lose control over how the money may be spent. Another potential disadvantage is that because the account is considered the child's asset, you can't switch beneficiaries. If your child decides not go to college or gets a scholarship, you can't switch the money to a brother, sister, or other family member as you can with 529 college savings plans.
You now can transfer funds from a custodial account, tax-free, to a 529 Plan. However, you must liquidate any investments you have made in a custodial account because you can only transfer cash and pay taxes, if any, on any gains. Another problem with transferring custodial account funds is that the money is the child's asset, not yours, so you cannot transfer the 529 plan to another beneficiary. There also may be other restrictions and limitations.