The account is just a normal brokerage account; therefore, you can use the assets to invest in any listed fund or security. The child is responsible for paying taxes on realized income and gains. Traditionally, custodial accounts have been popular because of a slight tax advantage. The first $850 of "unearned" income or investment income is tax-free, with the next $850 taxed at the child's rate, which is typically low. Income above $1,700 is taxed at the parent's rate.
A TAXING EXPERIENCE
That's a pretty good deal, but recent tax law changes have reduced the benefits of custodial accounts by raising the age for the so-called "kiddie tax." In a nutshell, the kiddie tax is designed to prevent parents from taking advantage of their children's lower tax rate. It used to apply only to children under the age of 14, but as of 2006, it was expanded to children under the age of 18. And in 2008, it will be expanded to full-time students between the ages of 19 and 23, as long as the student is a dependent of the parents. Now, for example, if your 17-year-old earns $3,000 from a custodial account, the first $850 is tax-free, the second $850 is taxed at your child's rate (though even lower if the income comes from capital gains), and the remaining $1,300 is taxed at your own marginal rate.
Of course it takes a fair amount of capital to generate $1,700 in realized gains or income, so a lot of parents aren't going to face the pitfalls of paying their marginal rates on their children's custodial accounts. But there is another worry for parents who believe their children will go to college: Custodial account assets are in the child's name, and financial aid calculations assess the child's assets at a much higher rate than those of the parents.
Colleges expect 5.6 percent of parental assets to be used for college, but they expect 33 percent of the child's assets to be put toward tuition, room and board. Realize, though, that these percentages are not absolute; retirement assets are not included, for example, and the formulas could change by the time your child goes to college. Since assets in a 529 plans are considered parental assets, while assets in a custodial account are the child's assets, the custodial account may not be your best bet: If you think your kid will go to college and if you believe you might qualify for aid.
BUILDING AN INTEREST IN INVESTING
I think it's clear that if your overarching goal is to save for college, the 529 plan offers a lot of benefits. It's tax-advantaged, you can put a lot of assets into it, and it's favorably treated when it comes to financial aid. But the custodial account is still worth considering; it does offer a modest tax break, it enables you to build some assets for your child's future (for example, if you want to set aside money for expenses that wouldn't be covered by a 529 such as piano lessons or travel abroad), and - this may be the biggest reason - it might help you engage your child's interest in the markets and investing.
I opened small custodial accounts for my sons when they were around 12 years old, and we talked about investing for the long term. They learned a lot about investing for growth and asset allocation. And because they have a stake in the markets, ideas are not abstractions but real money. They follow what's going on with their accounts because they know it's their money.
Bottom line? If you're saving for college, consider ramping up your contributions to a 529. But if you want to save for other goals or expose your kids to the investment world, a custodial account can fit the bill.
Just remember, when your son or daughter becomes an adult, the money is theirs to spend as they please. If you also take the time to teach them about prudent saving and investing, you'll increase the odds that they'll manage the money wisely when they do take control.
Carrie Schwab Pomerantz is chief strategist, Consumer Education, Charles Schwab & Co. Inc. You can e-mail Carrie at askcarrie@schwab.com.
