Financial Friday- Saving for your Child’s Education Part III

Custodial Savings Accounts

By Ratna*

Missed Part II of the series? Click here

This part of the series discusses Custodial Savings Accounts and summarizes in a table all of the tools available out there for college. Okay, “all” is a strong word. There are other vehicles out there for savings but I am only discussing 529s, Coverdell ESAs, and Custodial Accounts. Since a reader brought up how you can use a ROTH IRA for college savings, I added that to the table as well – lots of advantages to using a ROTH for college savings too! In fact, we had numerous responses last time and readers asked great questions and as you can tell, from those questions and answers, I too learned a few things. Keep in mind all the pros and cons of the different tools (summarized below), what your family’s goals are, and then choose the best way(s) to save but by all means- save!

Another useful method to save for education or even other costs such as a house, a car, or even the rising cost of a wedding these days is the Custodial Savings Account. Custodial Savings Accounts are just that- Savings Accounts that parents or guardians set-up and control until the child reaches age of majority (states define this at 18 or 21- check your state rules). In Colorado, the age of majority is 18. This is the biggest difference and the biggest drawback between all of the accounts discussed and the Custodial Savings Account is that the college-age student has complete control of this account and could use it for other than educational use. Moreover, the money in this account is not transferrable to anyone but the child designated on the account, and therefore, it does present risks if your college kid decides to use the money elsewhere.

Some of the positives of this type of account are that it is a savings account that can yield more interest and earnings than a regular savings or performance savings account for your child. So, if you get gifts of money from relatives over the years, you can put it in this account. But, a Custodial Savings Account is not limited to monetary contributions and you can put bonds, and other securities into the account. It will earn money for your child and build up money for either a car, a down payment on their first home, business start-up or any other purpose including education. That is why this account may be a useful in addition to the college savings options we discussed last week. Keep in mind that the first $850 in earnings EACH YEAR in the account is tax free but the next $850 is taxed at your child’s rate and then any earnings beyond that are attributable to your income (as the parent or donor) and taxed at your rate too. Withdrawals are not tax-free and are subject to federal tax as well – on your taxes if you still declare your child as a dependent OR on your child’s taxes if he or she is filing after age 18 or 21. Another advantage is unlimited contribution to this account but if you exceed the $12,000 IRS limit, you will pay gift tax on the contributions.

Some of the disadvantages are that you cannot switch beneficiaries and earnings and withdrawals are taxed – that’s double taxation which you avoid in the other options we discussed. You cannot switch beneficiaries and any withdrawals made by you while the child is under 18/21 must be for the child or you pay a penalty. If you already have money in this type of account, consider keeping it there and establish a 529 or Coverdell in addition to this. You cannot roll a Custodial Savings Account into the 529 and if you withdraw from the Custodial Account, you will have to liquidate its contents in order to get cash because the Custodial Account can have bonds, stocks, and other investments in it that are not cash unless sold or matured. 529s and Coverdells are cash contributions as is the ROTH.  So, keep this and other points in mind as you do your financial planning and tax planning. Here’s a handy table to help you summarize this series and help you and your children save in light of your income and your goals.

Type/Issues 529 Accounts Coverdell ESA Roth IRA Custodial Savings Acct
Tax Treatment Not taxed when withdrawn for education.  You receive tax deduction in State of establishment on your State filings yearly. Not taxed when withdrawn for educational purposes Not taxed when withdrawn (pre-taxed) and no penalty IF for EDUCATION The first $850 earnings is tax-free.  Next $850 is taxed at CHILD’S RATE (15%). >$1700  is taxed at your rate. Withdrawals are also Taxed
Penalties? Yes, if not for education and state can charge recapture for deductions too Yes, if not for educational purpose, can be penalized 10% penalty if not for education or retirement- no penalty/no tax for ed. No penalty IF withdrawn for the child but keep in mind that earnings are taxed + withdrawals
Fees for Management Yes- check your plan b/c they can be high Yes- check your plan but mimics IRA for fees Yes- check your company’s schedule Same as savings/checking acct
Freedom of Management No- state manages or plan owner- you can do a transaction 1x a yearThey choose what vehicle to invest in & it’s limited. Like an IRA, you can make changes a few times a year.  Broader range of investment options/vehicles. Yes- you have complete freedom on where to invest Yes you have complete freedom on where and how to invest.  You can put in cash, bonds, or other securities into it.
Contribution Limits $ No $$ limit per year – cash only contributions $2000; subject to high income phase-out by IRS rules; cash only $5000 (unless over 50- then $6000); subject to high income phase-out No limit but > $12,000 subject to gift tax- can invest bonds, securities
Affect on Financial Aid? Yes- counts as income for financial aid against DONOR/Parent Yes- counts as income for financial aid against the donor/parent Yes- does get reported as income for financial aid but vs. the parent who withdraws the $$ Yes- counts as income vs. the child so affects financial aid eligibility
Use or Lose? YES- unless you transfer YES- unless you transfer or use it up No- can use for retirement if not for education No but at age 18 or 21, becomes the child’s account (state law)
Transferable? Yes- to siblings, cousins, parents, etc. Yes- and can roll into 529 as well No unless it is a joint account No- you designate the child (not transferrable); no roll-over options
Age Limits on use? No No No No
Can Child control this account? No- parents or donors control it- not the child No- parents or donors control – not the child No- unless it is in their name and not yours. Yes- you control until child reaches 18 or 21 (Colorado is age 18) Then they get to do what they want w/ $$$
Type of Use College, university, vocational, Community College but Post-High School Primary, Secondary education & college, university, etc (post High school) Any educational use stated in 529 Accounts- College, University, etc Any purpose you would use savings for- anything like education, marriage, boat, car, etc.

*Disclaimer: All parts of this series were written by the author in her personal capacity and not attributed to her profession, or any organizations, employers, or the like that author is affiliated with. The author is interested in these topics and blogs for recreational purposes and not for financial gain. All views and opinions are of the author and not attributable to any company and not meant as an endorsement to any company or organization. Most importantly, author is not a financial expert, tax attorney, estate planner, or accountant, nor works in the financial planning field. This article is written solely for the purpose of sharing information and knowledge with the readers. All readers should consult with their own attorney, tax planner, financial or estate planner, and/or accountant prior to making investment decisions. The author is not liable and will be held harmless for any investment loss or risk undertaken as a result of opening any of the accounts aforementioned.

Comments

  1. Do you know the age limit in Colorado for when the kids get control? We have custodial accounts for our kids (not much money in them), that is to go to college, but I don’t know that I trust the kids to use it that way. If the age is 21, I’m comfortable, but at 18, I’m not and may consider withdrawing it so they have it available for college.

  2. Hi, Daria- thanks for the questions. It is 18 in Colorado but I would not recommend you withdraw because of all the taxes and penalties you would pay. I would do what my parents did- just don’t tell me about it. Ha! Kidding. But closer to their age 18 think about what you want to do then. My in-laws used custodial accounts for weddings and house down payment for the specific child it was established for. You can use it to help for college too. But I would not be quick to remove it yet. The kids may surprise you yet.