Saving for College: Custodial Accounts

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

• The benefits: You can take advantage of the gift tax exclusion to fund the account. You can control how the money is invested with many choices available to you while your child is still a minor. You also have flexibility in terms of how the money is spent as long as it's used for the benefit of the child.
• The drawbacks: You can't change the beneficiary of a custodial account once it's established. Your child can use the money however they want after reaching a certain age, and investment income in custodial accounts may trigger the kiddie tax. The account can impact financial aid eligibility.

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 typically established for a child and managed by a custodian, typically a parent. However, when the child typically reaches age 18, 21, or up to age 25, depending on the state of residence, legal control of the account automatically becomes theirs.

For example, let's say a parent is managing a custodial account for their daughter. They may both agree that the money is for college expenses, but when the daughter turns 21, the account reverts to her and she can use the money for anything she wants—college, new car, vacation, or almost anything else.

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

In contrast, 529 plans and Coverdell ESAs give much greater control to the account owner, typically a parent, 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 to receive tax advantages.

The key is knowing how and under which circumstances to use the various options. For example, custodial accounts can supplement a 529 plan or an ESA for a child's college education. If a parent wants 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 helpful.

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 $18,000 per year ($36,000 for a married couple) in 2024 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. To learn more, see IRS Publication 929.

Custodial accounts can have a heavy impact on financial aid. Because the money in a custodial account belongs to the child and not the parent, 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 is that the UGMA/UTMA 529 account would still be considered a parent-owned asset treated more favorably than the child under FAFSA. Keep in mind, 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 plan allows the transfer of custodial account funds. 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 on the UGMA/UTMA custodial account. You can't 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, most financial aid comes in the form of loans, which must be repaid with interest.