Gift that keeps on giving:
“I wish Larry Jr. had a better understanding and appreciation for money,” his dad said. “I’d like to find a way to make him feel that he’s a part of our family finances, without just handing over money every time he asks.”
Instead of giving the usual gifts this holiday season, this smart dad is thinking of setting up a custodial account for Larry Jr. that will help his son gain some financial planning know-how. With the account, by the time Larry Jr. turns 21, he will have access to—and hopefully a good plan for—this financial gift. This is just one of the advantages of custodial accounts. These accounts are simple and flexible, and anyone can open one, no matter their income level.
Custodial accounts have been around for years and are used to hold and protect assets until a child reaches the age of 21 in Colorado (this age is different in each state). Although there are other options to help the kids financially, such as starting a 529 account for college, opening a 401(k) on their behalf or setting up formal trusts, a custodial account works best in some circumstances. You should investigate all gifting options available to find the one right for you and your child.
These custodial accounts, known as UGMAs (Uniform Gifts to Minors) and UTMAs (Uniform Transfers to Minors), allow the donor to gift all types of securities, such as bank deposits, real estate and stocks. UGMA accounts are a bit more restrictive.
A great advantage for custodial accounts is the tax savings, aka the “kiddie tax.” The first $1,000 of unearned income is tax exempt from the minor child. The second $1,000 of unearned income is taxable at the child’s tax rate, and you may need to file a tax return for your youngster. Any amounts over $2,000 are taxable at either the child’s or the adult’s tax rate, whichever is higher. State income taxes may also be due. The annual federal gift tax exclusion is currently $14,000 per year ($28,000 for married couples). An UGMA or UTMA does not affect the $1 million federal gift tax exemption.
Be sure that this is the route you want to take as the money is irrevocable. This means the custodian or a donor cannot withdraw any of the funds. However, under some circumstances, the money may be used for the benefit of the custodial child before he or she reaches “adulthood.” Education expenses, as well as, non-educational expenses, such as a personal computer, qualify as long as these expenses are not considered the basic essentials of living. Essentials such as food, clothing, shelter and even general medical care, do not qualify since these costs are regarded by the IRS to be parental obligations.
In Colorado the day the child becomes a legal adult he or she will have full access to the funds. No restrictions are placed on these funds so if the recipient wants to spend the money unwisely, even if the custodian had something else in mind, he or she is free to do so. This is unlike other accounts, such as a 529 or Coverdell Education Savings Program, which can only be used to pay for education expenses.
Another issue to note is that this account could affect eligibility for financial aid for college. Once the recipient is of age, the money in a custodial account becomes an “asset.” These assets are considered part of the student’s total finances and could affect eligibility. If you feel this may be an issue it could be that a 529 account is a better option.
Becoming a custodian of an account such as an UTMA and UGMA comes with restrictions and responsibilities other than those cited here and while there are benefits to custodial accounts there are also constraints and may not be a good option for everyone. Be sure to fully understand the restrictions and speak to your tax or financial professional about alternatives.
Whichever strategy you take, one thing is for sure, preparing your kids to become savers and teaching them the benefits of financial planning for the future is a good thing and one of the best gifts they could receive this holiday season.