What Parents and Grandparents Need to Know About Custodial Accounts

Parents and grandparents establish custodial accounts for children for various reasons. For example, grandma might want to set aside $10,000 for her granddaughter, or maybe Mom and Dad want a tax shelter for their child’s savings. However, many folks who establish custodial accounts fail to recognize these accounts have significant legal and tax implications.

Here are five important facts parents (and grandparents) need to understand.

The Money Now Belongs to the Child

Once transferred into a minor child’s custodial account at a financial institution or brokerage firm, the funds then irrevocably belong to the child. While the parent can, and usually does, function as the custodian (manager) of the account, the money can legally be used only for expenditures that benefit that child. In other words, parents legally can’t use custodial account money for expenditures that benefit themselves (like a new car). Parents also can’t take money from one child’s custodial account and use it to open up or supplement an account for another child.

While you rarely hear about parents getting into legal hot water for dipping into custodial accounts, be careful not to stray over the line.

The Child Will Gain Control at a Relatively Young Age

Parents or grandparents must establish a minor child’s custodial account under the applicable state Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA). Most states have UTMA regimes these days. In any case, under applicable state law, the child will gain full legal control over the account once he or she ceases to be a minor. This will happen somewhere between age 18 and 21 (in most states the magic age is 21).

Remember, small children eventually may turn into teenagers and young adults who are not responsible with money. It’s important to consider the possibility of future “UGMA or UTMA regret” before taking the irrevocable step of putting a substantial sum into a child's custodial account.

The Child May Have to File Tax Returns and Pay Taxes

Any income from a child’s custodial account belongs to the child. If that income exceeds certain thresholds, you’ll need to file a separate federal income tax return for the child using Form 1040, 1040A, or 1040EZ. The child will probably owe some tax, and the Kiddie Tax rules may make it higher (read more about the Kiddie Tax below). A state income tax return may be required, too.

Exception: If all of the child’s income consists of interest, dividends and mutual fund capital gain distributions, the parent may be able to simply include the income on the their Form 1040 and pay the resulting extra tax with that return. Details about this option are explained on IRS Form 8814, Parents' Election to Report Child's Interest and Dividends.

The Kiddie Tax Might Apply

It would be nice if children with substantial custodial accounts could pay the same tax rates on investment income as other unmarried individuals. If that was allowed to happen, a child’s ordinary income would typically be taxed at a federal rate of only 10% or 22%, and a 0% or 15% rate would typically apply to long-term gains and dividends.

Unfortunately, Congress created the so-called Kiddie Tax to prevent such happy outcomes.

Under the Kiddie Tax rules, a minor child’s investment income above $1,100, some or all of which may come from assets in a custodial account, may be taxed at the parent’s higher rates. This is true even if all the money to fund the custodial account came from a grandparent or someone else other than a parent. Therefore, if the parent is a high-income individual, the federal income tax rate on a child’s interest income could be as high as 37%, with long-term gains and dividends taxed at up to 20%.

Use Form 8615, Tax for Certain Children Who Have Unearned Income, to calculate tax on unearned income over $1,100 for those under age 18 or on the aforementioned Form 8814 (when allowed).

Important point: Years ago, a child’s custodial account could function as an efficient tax shelter because the income was taxed at the child’s low rates. These days, the Kiddie Tax rules make it more difficult for custodial accounts to deliver meaningful tax savings.

There Could Be Gift Tax Consequences

A parent can take advantage of the annual federal gift tax exclusion to move up to $15,000 into a custodial account for each of his or her children. If the parent is married, so can the spouse. Parents can do the same thing year after year. Gifts up to the $15,000 annual limit will not reduce the parents’ unified federal gift and estate tax exemption ($11.7 million).

However, if a parent transfers more than $15,000, they must file a gift tax return on Form 709, United States Gift and Generation-Skipping Transfer Tax Return, even when no gift tax is due. Thanks to the generous exemptions, the parent probably will not actually owe any gift tax, but should still file a gift tax return.

The same gift tax considerations apply to gifts by grandparents and others.

There are alternative ways to transfer money for the benefit of your children or grandchildren, including:

• Contribute to a college savings account or 529 plan, which can be up to $75,000 from each grandparent or parent for each child. Parents and grandparents can control these funds to ensure the money goes to expenses for college. The additional benefit of qualified college savings is limited state income tax deductions, and the funds grow tax deferred and are not taxed at all if used for education.

• Set up a trust to control the funds for your grandchildren’s or children’s benefit. The terms of this type of trust are fixed when established, but provide a longer term control over assets if you are gifting an amount that you would not want a child to have access to at a relatively young age.

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