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Opens the scrolled simulated dialogImportant Disclosures

Investing In Your Child's Name

If you want to open up an account and give your minor child assets that you currently own or make investments in their name, you may want to consider opening a custodial account. You can do this under the Uniform Gifts to Minors Act (UGMA) or the more widely used Uniform Transfers to Minors Act (UTMA) - which one varies by state.

In most states, a minor isn't legally entitled to sign a contract or own assets directly. So you, or someone you appoint, can act as custodian and manage the account for the child's benefit. The major differences between the two types of accounts are the variety of assets you can gift and the age that the beneficiary is entitled to gain control of the account's value. In both cases, all gifts to a custodial account are irrevocable. They are held in the child's name and must be used for the child's benefit.

Custodial Accounts

Most banks and brokerage firms offer custodial accounts. Anyone can establish an account for a child simply by making a donation, naming a minor as account beneficiary, and appointing a custodian.

There are no annual or lifetime limits to the amount you or other donors can contribute to a custodial account. Additionally, anyone, not only the custodian, is eligible to add assets to an UGMA or UTMA account, regardless of his or her income. That said, for tax purposes, it's often smart to limit an annual contribution to the amount of the tax-free gift that can be made to any individual during the year. In 2014, that's $14,000, or $28,000 if you're married and filing a joint return. If you gift more, you may have to file a gift tax return and may eventually owe gift taxes.

Unlike education savings plans such as 529 plans and ESAs, custodial accounts place fewer restrictions on your withdrawals. In general, you can use a custodial account to pay for any expenses that benefit the child, as long as they are not considered the basic essentials of living. Specifically, you can use UGMA or UTMA account assets to pay tuition or other education expenses, as well as certain non-educational expenses, like a personal computer. But you may not purchase food, shelter, or clothing for the child with money from the account, since the IRS considers basic costs parental obligations.

Potential Limitations

Despite their usefulness, there are potential drawbacks to thinking of an UGMA or UTMA, especially as a college planning strategy. Also, in the case of a brokerage account, you'll face the risks of investing in the market.

Once your child assumes control of a custodial account, he or she is free to spend the money in any way. While you may hope your goals and your kid's goals are similar, especially when it comes to paying for major expenses like college, your wishes may be ignored in favor of personal priorities, say, a new car or a trip around the world.

And you may want to think twice before opening a custodial account if you think your child will apply for federal student aid when it's time to attend college. Since custodial accounts are the property of your child, they may have a larger impact on his or her chances of qualifying for need-based loans. Students are expected to contribute 20% of their savings toward their college educations in any year while parents are expected to contribute just 2.6% to 5.6%1.

Tax Issues

The earnings and income from custodial accounts are taxable, not tax free as they are in an ESA or 529 plan. Once your child turns 19, or 24 if he or she is a full-time student, any income and capital gains on assets in the custodial account are taxed at his or her rate. That rate might be as low as 10% or 15% for interest income and 0% for qualifying dividends and long-term capital gains income, depending on his or her total income.

But, until the applicable age is reached, most of the income tax that's due on any taxable investment income is calculated at the parents' rate. (A limited amount of the income is tax free, and an equal amount is taxed at the child's rate. In 2014, it's $950 in each of those categories.) That's another reason, from the college planning perspective, why these accounts may have limited value.

What's more, assets in a custodial account where you're the custodian are considered part of your estate until the child reaches majority. So any potential estate tax savings would not apply if you were to die before they reach legal adulthood. Since many people use these accounts specifically to reduce the size of their estates, it is a consideration.