In the first half of this two-part column on investing in your kids, I focused on saving for college, primarily through 529 plans. But in addition you can invest in other parts of your kids' future, and perhaps encourage them to learn about the markets and investing in the process. This is where custodial accounts can play an important role.
Custodial accounts have been around for a long time. Depending on your state, they are referred to as "Uniform Gifts to Minors Act" or "Uniform Transfers to Minors Act" accounts. Realize, though, that when you set up a custodial account, you give the assets to your minor child. You manage the money on your child's behalf until he or she reaches the age of 18 or 21, according to your state's laws, (although note that in some states, like California, a parent can designate an older age) but you can never take it back.
The account is just a normal brokerage account; therefore, you can use the assets to invest in any listed fund or security. The child is responsible for paying taxes on realized income and gains. Traditionally, custodial accounts have been popular because of a slight tax advantage. The first $850 of "unearned" income or investment income is tax-free, with the next $850 taxed at the child's rate, which is typically low. Income above $1,700 is taxed at the parent's rate.
A TAXING EXPERIENCE
That's a pretty good deal, but recent tax law changes have reduced the benefits of custodial accounts by raising the age for the so-called "kiddie tax." In a nutshell, the kiddie tax is designed to prevent parents from taking advantage of their children's lower tax rate. It used to apply only to children under the age of 14, but as of 2006, it was expanded to children under the age of 18. And in 2008, it will be expanded to full-time students between the ages of 19 and 23, as long as the student is a dependent of the parents. Now, for example, if your 17-year-old earns $3,000 from a custodial account, the first $850 is tax-free, the second $850 is taxed at your child's rate (though even lower if the income comes from capital gains), and the remaining $1,300 is taxed at your own marginal rate.
Of course it takes a fair amount of capital to generate $1,700 in realized gains or income, so a lot of parents aren't going to face the pitfalls of paying their marginal rates on their children's custodial accounts. But there is another worry for parents who believe their children will go to college: Custodial account assets are in the child's name, and financial aid calculations assess the child's assets at a much higher rate than those of the parents.