Are you seeking options for helping your minor-aged child save for college or other expenses in a tax-efficient manner? A custodial account may be the answer. In a nutshell, it’s a financial account for children under 18 that’s opened and controlled by parents or grandparents. Let’s take a closer look at two types of custodial accounts and detail their pros and cons.

UGMA vs. UTMA

One of the simplest ways to invest on your child’s behalf is to open a custodial account under the Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA). These accounts — available through banks, brokerage firms or mutual fund companies — are owned by the child, but managed by the parent or another adult until the child reaches the age of majority (usually 18 or 21). When the child comes of age, he or she takes over ownership and control of the account.

The biggest difference between a UGMA account and a UTMA account is that the UTMA covers more assets. For example, with a UGMA account, you can include assets such as stocks, bonds and mutual funds. With a UTMA, you can also include such assets as real estate, jewelry and art.

Pros and cons

One of the biggest advantages of using a custodial account is its flexibility. Indeed, unlike some savings vehicles, such as Coverdell Education Savings Accounts (ESAs), anyone can contribute to a custodial account, regardless of their income level, and there are no contribution limits. Also, there are no restrictions on how the money is spent. In contrast, funds invested in ESAs and 529 plans must be spent on qualified education expenses, subject to stiff penalties on unqualified expenditures.

Contributions to custodial accounts can also save income taxes. A child’s unearned income up to $2,500 per year is usually taxed at low rates. (Income above that threshold is taxed at the parents’ marginal rate.)

On the downside, other savings vehicles can offer greater tax benefits. Although custodial accounts can reduce taxes, ESAs and 529 plans allow earnings to grow on a tax-deferred basis, and withdrawals are tax-free provided they’re spent on qualified education expenses. There may also be financial aid implications, as the assets in a custodial account are treated less favorably than certain other assets.

Finally, there’s a loss of control involved with custodial accounts. After the child reaches the age of majority, he or she gains full control over the assets and can use them as he or she sees fit. If you wish to retain control longer, you’re better off with an ESA, a 529 plan or a trust.

Right for you?

Determining whether a custodial account is right for you requires an assessment of your financial circumstances and investment goals. Your financial advisor can help make the right call.

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