Saving for College: Custodial Accounts

If you want to set aside money for college expenses that aren't covered by an Education Savings Account or 529 plan, a custodial account can help.

• The benefits: You can take advantage of the gift tax exclusion and control how the money is invested and spent for the benefit of the child while your child is still a minor.
• The drawbacks: Your child can use the money however he or she wants after reaching a certain age, and investment income in custodial accounts may trigger the kiddie tax.

Custodial accounts—also known as UGMA or UTMA accounts after the Uniform Gifts to Minors Act or Uniform Transfers to Minors Act that created them—are created for your child and managed by you. However, when your child reaches "termination age"—typically 18, 21, or 25 years, depending on your state—the money automatically becomes his or hers.

For example, let's say you're managing a custodial account for your daughter. You may both agree that the money should be used for college, but when your daughter reaches termination age, the account reverts to her and she can use the money for anything she wants—college, a new car, a vacation, or something else entirely.

The main benefits of a custodial account are that you can take advantage of the gift tax exclusion while maintaining control over how the money is invested and spent while your child is a minor (as long as it is for their benefit). However, the exclusion requires that the money be an irrevocable "no strings attached" gift.

In contrast, 529 plans and Coverdell Education Savings Accounts (ESAs) give you much more control over how the funds are used, including the ability to change beneficiaries as the need arises. The main limitation being that the funds must be used specifically for certain education expenses in order to receive tax advantages.

The key is knowing how and under which circumstances to use the various accounts. Custodial accounts can supplement a 529 plan or an ESA for your child's college education. If you want to set aside money for college expenses that aren't covered by an ESA or 529 plan—sorority dues or car repairs, for example—a custodial account may be just the thing your child needs.

The table below shows how custodial accounts compare to 529 plans.

You can open a custodial account at virtually any brokerage or financial institution. The minimum to open such an account generally ranges from $500 to $2,000.

Anyone (parents, grandparents, other relatives, and friends) can make unlimited contributions to a custodial account once it's open. However, a person can't contribute more than $16,000 per year ($32,000 for a married couple) in 2022 without potentially triggering a gift tax. 

Unlike 529 plans and ESAs, custodial accounts are subject to the so-called "kiddie tax." This tax rule applies to unearned income (i.e., investment income) up to a certain threshold. Over that threshold, the child will pay taxes at the parent's tax rate.

Custodial accounts can have a heavy impact on financial aid. Because the money in a custodial account is your child's asset and not yours, federal financial aid formulas consider 20% of the money available to pay for college. Compare this to 529 plans, which are given more favorable treatment for financial aid. (The Free Application for Federal Student Aid (FAFSA) formula considers a maximum of 5.64% of the money to be available in a parent-owned 529 plan available for college because the money is considered the parent's assets and not the child's.)

While you can't roll over or directly transfer custodial account assets into a 529 account, you can cash out and reinvest the proceeds in a custodial 529 savings plan for the same minor. The benefit for doing so is that the UGMA/UTMA 529 account would still be considered a parent-owned asset and assessed at the 5.64% rate under FAFSA. Keep in mind that you'll be subject to pay taxes on any gains if you choose this option.

Additionally, not all 529 plans automatically allow for the transfer of funds from custodial accounts. Check to see if your 529 allows custodial account funds to be transferred. And remember, if you set up a custodial 529 account, the money can only be used for the same child specifically listed as the beneficiary of the UGMA/UTMA custodial account. You cannot rename the beneficiary and use the assets for another person.

Saving and investing for college is a wise move, even if you believe your child may qualify for financial aid. Remember, the majority of financial aid comes in the form of loans, which must be repaid with interest.