5 Things to Know About Opening Custodial Accounts

As parents, you want to get your children set up on the right path. You want to ensure that, should rough times fall upon you or your career, your child’s future is protected. It’s a scary thought, but one you no doubt must consider. It is one of your only means of protecting your child from the trials and tribulations that could potentially come your way, and you don’t want your children to suffer negatively as a consequence of your misfortune. The problem is, some people set up custodial accounts for flagrant uses.

For instance, some parents have used their children’s accounts to qualify for a lower tax bracket. However, most people use custodial accounts as they’re meant to be used; which is to say, they put money aside for their child for when they come of age—like a preemptive savings account. That’s a good thing!

With that being said, in order to properly set up a custodial account for your loved one, there are a few things you should know. After all, if you don’t know everything there is to know about these types of savings plans for kids, you may end up providing less than you thought.

Here’s what you need to know for starters:

1. The money doesn’t belong to you anymore.

That’s something that needs to be said. You don’t own that money anymore—you manage it. Once the money is transferred into a custodial account, you cannot withdraw from it to buy yourself a new car. For all intents and purposes, that money now belongs to your child. They may not be able to use it right away (usually there’s a set age when they get access to it), but it is theirs.

For most parents, making that money their child’s is precisely the point. Why wouldn’t you want that? Well, some parents jump into a custodial account not realizing that they cannot touch it even if they have a second child. In other words, if you budgeted a set amount for your first and only child, and then you end up expecting another child, you cannot split those funds between the two of them.

You would need to create a new account. Reason being, the money can only legally be used to benefit the child it belongs to. This means that, while you can withdraw the funds, they cannot legally be used to benefit yourself. It must go toward your child’s livelihood, their education, their health, etc.

2. Becoming “of age” doesn’t make a child responsible.

Almost all custodial accounts become available to the beneficiary when they turn 21 (although, in some states it’s 18). However, even though your child is of age and therefore able to access the funds, it doesn’t mean they’re going to use those funds for their benefit.

By 18, your child has become a legal adult even though they may still think and act like a teenager. Be mentally prepared to understand that while you may have intended for the money to go to their college tuition, they are not obligated to use it for those purposes.

You can only use the money to benefit your child, but once your child becomes of age, they can use it however they see fit. For some parents, this is an issue and it’s definitely one to take into consideration before opening a savings account of this nature.

3. Taxes still apply.

The last thing you want is to set aside the perfect amount for your child to later discover that they’re only going to get 85-90% of it. There are a number of hoops to go through in order to avoid being taxed, but typically, if your child’s unearned income exceeds $2,100, then they will need to file taxes. For example, according to the IRS in 2016, your child will need to pay taxes if: he or she is under the age of 18 at the end of the tax year; if their earned income does not exceed one-half of their own support; or if they are a full-time student in between the ages of 19 and 24 and their income did not exceed half of their investment.

Now that said, parents can elect to pay these taxes themselves by attaching Form 8814 with their standard 1040 and sending it to the IRS. The short version is, it’s important to keep these elements in mind when electing for a custodial account.

4. Beware the “Kiddie Tax.”

This is an especially unforgiving tax that can drain your well-meaning custodial account for your child. Normally kids would be taxed the standard 10-15% federal rate, but there’s a Kiddie Tax that can say otherwise.

Believe it or not, the Kiddie Tax enables the government to tax your child’s income at your (the parents’) rate. This means interest can be as high as 20-35%! Not a great system and certainly not better than a standard savings account.

5. There’s an eventual Gift Tax.

There is a limit on the amount of money you can gift someone, and we don’t just mean the $14,000 limit. For those who don’t know, you can gift up to $14,000 to your child in any given year, making it free from taxes. However, each time you gift money, you need to file a form (in this case Form 709) that indicates that expense. And there is a lifetime limit on your gift exemptions. If you exceed $5.25 million in gifts, you could be hit with a tax.

Of course, most people don’t hit this limit, but it’s something to bear in mind.