Because individuals must be of legal age to own property, many parents use custodial accounts as ways for moving funds and assets into their children's names.

The concept of custodial accounts was originally established under the Uniform Gifts to Minors Act (UGMA). These accounts were an easy and legal way to transfer the ownership of assets to a child. UGMA accounts were fine for financial assets such as cash, bonds or stocks. Recently, most states have adopted the Uniform Transfer to Minors Act (UTMA) that provides some additional capabilities for the property to consist of real estate or other more complicated types of property. 

With a UGMA or UTMA account, the parent creates a custodial account on behalf of the minor child. Assets are transferred into the account and the custodian, usually a parent, manages the account until the child reaches legal age. At that point, the child can do whatever he or she wishes with the assets.

These accounts are often used to save for college educations or to create some net worth for a child. While they are usually established by a parent, other adults (such as grandparents) can establish UGMA or UTMA accounts and act as custodian.

Transfers are irrevocable

If you are considering transferring assets into a custodial account, remember that the gift is irrevocable. You cannot change your mind later and take the assets back. Your child becomes the owner when you make the transfer. Most states set 21 as the age when the custodial accounts end. However, some states set age 18, between 18 and 21 or between 18 and 25. Check the laws of your state.

Gift tax implications

Transfers into a custodial account are just like any other gift. You can make annual gifts up to $14,000 in cash, securities or other property to anyone without owing any federal gift tax and without filing a gift tax return. The annual exclusion applies to each person receiving the gift. If you are married, gifts can be considered to be one half from you and one half from your spouse. In other words, two parents can give up to a total of $28,000 per year to a child without owing any gift tax. However, a simple gift tax return may be required if you use this gift-splitting technique. Consult your tax advisor.

How children are taxed

Generally, children are treated as separate taxpayers and their income is taxed at the same marginal rates as their parents. The tax table used to calculate their tax is the single filer table. The lowest rate is 10% and the rates rise to 39.6% (for 2017) for the highest levels of income. Rules for 2017 Returns These rules will apply to children under the age of 18, 18 year olds with earned income less than half of their support, and 19 to 23 year old students with earned income less than half of their support.

If a child has a job, their earned income is taxed regularly. In fact for 2017, the first $6,300 is usually tax free (by taking advantage of the standard deduction). Then income is taxed at the child's marginal bracket, usually 10%. Even if the child has less than $6,300 of earned income, a tax return may still be necessary to get a refund of any taxes that were withheld at their job.

If the child has unearned income from interest, dividends or capital gains, the rules get a bit more difficult. If the child meets any of the three criteria described above, the first $1,050 of unearned income is not taxed and the next $1,050 is taxed at the child's tax rate. All the unearned income above $2,100 is taxed to the child, but at the parent's tax rates.

This complication, known as the Kiddie Tax, was enacted to prevent families from shifting large amounts of investment income to children to avoid having it taxed at the parent's higher rates. The interaction between the Kiddie Tax and the parents' tax situation can become very complicated if the parents have an unusual tax issue like the Alternative Minimum Tax or relatively large amounts of capital gains. In those cases, a qualified tax advisor is a must.

Qualifying for college financial aid

Using a UTMA or UGMA account to receive assets transferred from parents may limit or reduce your child's ability to qualify for needs-based financial aid to cover college costs. This is because many financial aid programs require the student to use 35% of their assets for college before being eligible for aid. The same programs may only require 5% of the parents' assets to be used in the calculation. You may want to investigate this if your child's qualifying for financial aid is going to be important.

Summary

Custodial accounts are an easy and convenient way to transfer funds to children. There are limited income tax benefits and there may be negative implications for your child's ability to qualify for college financial aid. However, often the major factor to consider is that your children will be able to use the funds as they please once they reach a certain age. This is all the more reason to make sure your children have a proper financial education.