Today, there are a number of ways to save for higher education. Parents can take advantage of pre-paid college plans, Section 529 plans and Coverdell Educational Savings Accounts (formally the Education IRAs) to name a few. All of these plans have both strengths and weaknesses.
Custodial Accounts also have strengths and weaknesses. Unlike the Coverdell Educational Savings Accounts and Section 529 Plans, money can be withdrawn without a 10 percent penalty when the distribution is not used for higher education. Therefore, if you are not sure if the funds will be used for college, the custodial account may be an attractive option for gifting to a minor. The Uniform Gifts to Minors Act is adopted by states but often they adopt them in principle with a series of amendments that make them particular to their state. So depending on where you live, particulars such as age of majority and the instruments that a UGMA/UTMA can hold will vary. The original law (UGMA) was adopted in 1956 to provide a way to make gifts of money and securities to minors without the need to formally establish a trust. In 1986 the Uniform Transfer to Minors Act (UTMA) was introduced to expand the types of property eligible to transfer to a minor.
For the tax year 2006, IRS regulations allow an irrevocable gift of up to $12,000 to a minor with no gift tax consequences to the donor. Custodial Accounts provide a way for a minor to own assets without involving an attorney to set up a formal trust. The terms of the UGMA/UTMA are set in state statue not in actual trust agreements.
When gifting assets to a minor, a custodian must be set up on the account because in most states a minor cannot enter into a contract. The custodian controls the management of the gifted property. When the child reaches age of majority (age 18 or 21 depending on your state regulations) the child takes over ownership of the account. The child can spend the savings on anything they see fit, which may be in direct conflict with the desires of the donor.
For children under the age of 14, earnings on custodial accounts are tax-free up to $750. Earnings from $750 to $1,500 are taxed at the child's tax rate (typically 10 percent). Earnings over $1,500 are taxed at the parent's highest marginal rate. For children over the age of 14, the earnings are taxed at the child's rate.
Most financial experts agree that one of the most important steps when planning to send children to college is to prepare early! There are many types of college funding vehicles that can be utilized to help send children to college. A financial professional can help you develop a disciplined approach to saving for college costs. Together, you can determine which college-funding vehicle will work best for your family.
This article is not intended to provide tax advice. Be sure to consult your tax professional regarding your individual circumstances.
Advisor is an independent financial planner based in Manchester, NH