Problems with Custodial Accounts


Reasons to be cautious about the use of custodial accounts.

Before you set up a custodial account for a minor, consider whether an UGMA or UTMA account is the best choice. These accounts are well suited to relatively small dollar amounts because they're quick, cheap and simple. But if you're thinking of transferring many thousands of dollars to a child, you should strongly consider seeking the advice of a lawyer who's experienced in handling trusts and estates. Here are some of the concerns:

You can't take it back

Once you've transferred assets into a custodial account, you're not permitted to take them back. Those assets belong to the child. You probably can't take the assets back even with your child's consent, because your child isn't old enough to give valid consent on such matters. Never transfer assets to a custodial account if you have any concern whatever that you may need to recover those assets later.

Did you say age 21?

When your child turns 21 (or an earlier age, in some states), the custodian must turn the assets over to the child. Some people are mature and thoughtful at age 21 or earlier; many are not. Do you really want all that money in your child's hands at that age? How will you feel if she uses it to buy equipment for her boyfriend's rock band?

Financial aid

Some people think of a custodial account as a good way to save for college, and learn only later that the account causes a reduction in financial aid. Under current law, assets owned by the child (including any assets in a custodial account for the benefit of that child) count much more heavily than parental assets in determining how much financial aid the child qualifies for.

This fact shouldn't necessarily turn you off to custodial accounts completely. Most financial aid is in the form of loans, so a reduction in financial aid often means a reduction in debt coming out of college, which isn't necessarily a bad thing. Yet many people erroneously suppose that they don't qualify for financial aid when in fact they do. For children who are college-bound, the availability of financial aid is a relevant concern in setting up a custodial account.

One child only

A custodial account belongs to only one child. Too often parents set up a custodial account for one child and find that they can't establish a comparable account for a later child. Perhaps they "hit home runs" with their investing choices for the first account, and now it's so large they can't make a "catch-up" gift for the later child. Perhaps they simply don't have the same resources they had when they established the first child's account.

You aren't allowed to transfer money from one child's custodial account to an account owned by a different child. That can be a real dilemma for parents who are intent on treating their children equally. A trust can be set up for the benefit of all your children, but a custodial account is owned directly by the child named at the time it was established.

Estate tax blunder

If you're concerned about estate taxes, it's important to avoid naming yourself as custodian. The reason is that if you die before the account terminates, the account will be included in your estate. This is true even though the transfers to the account are completed gifts. The account is included in your estate because you retained the power to determine how your gift will be applied for the benefit of your child. You can avoid the problem by naming as custodian someone who will not make any gifts to the account. For example, a grandparent might name the parent as the custodian.

Income tax issue?

You have a legal obligation to support your child. If you use income of the custodial account to satisfy that obligation, the IRS may contend that the income will be taxed to you in that case, not to your child. There is little recent guidance on this issue and it isn't clear that this rule should apply to accounts established under the more modern version of the custodial account law, because UTMA contains language designed to prevent parents from being taxed on custodial account income when the account is used for purposes that fall within the parent's support obligation. If you are concerned about this issue, you should use the account only for items that supplement your legal obligation to support the child. Exactly where to draw the line is the subject of much debate, and may vary depending on your economic status and the particular state law that applies.

Death of the child

If your child dies before receiving the account, the assets will pass according to the law of your state. Often the result is not what you would have wished, especially if the child has siblings. When you establish a trust for your child, you can plan for this possibility. The Uniform Transfers to Minors Act doesn't provide this flexibility.

Alternatives

Before establishing a custodial account, you should carefully consider your objectives and other ways you may achieve them. You may find that you're better off putting money into a Coverdell account, a 529 plan, or even a traditional IRA or a Roth IRA, instead of a custodial account. Another possibility is to set up a trust. There's some cost involved in establishing a trust, but often it's less than you expect. If you're dealing with a lot of money, the advantages may be far greater than the cost.