It’s once again time for that January ritual, funding our Roth IRAs and Coverdell Education Savings Accounts for the year. This started me thinking about a Uniform Gift / Transfers to Minors Act (UGMA / UTMA) custodial account. These accounts are owned by minors but managed by an adult custodian. One upside of a custodial account is that the gains from the account are taxed at the child’s rate. The downside is that once the money has been deposited, it can’t be taken back – it’s a permanent gift to the minor. The money can be spent on the child’s behalf (e.g., education expenses, travel), but the child gains control as soon as they reach legal age – generally 18 or 21 depending on the state. The money will also factor into college financial aid applications as part of the child’s assets.
Perhaps the biggest concern is what happens in 15 years when that toddler turns 18? Will he or she be responsible enough to make “appropriate” decisions when they learn they have $50,000, $100,000, or more in the bank? I hate to think about what mistakes I would have made if I had been given $50,000 when I was 18.
While parents can describe a custodial account as an account earmarked for college, a first home, or retirement, the child is legally free to spend the money as they wish once they are of legal age.
I’ve read about some parents that simply keep the accounts a secret from the children until they are 30 or 40 years old. While that’s always a possibility, I don’t understand how the taxes are handled (the accounts are not tax deferred so the children would have to report the gains on their income taxes.) Perhaps the best course of action, whether a child has a custodial account or not, is to educate children about finances and prepare them to make the “appropriate” decisions.