by: Richard A. Anderson, CFA
There are myriad ways to save for higher education expenses and choosing the best college savings account depends on your personal needs and preferences.
Ever since Congress passed the Small Business Job Protection Act in 1996, which established 529 college savings plans as a tax-advantaged investment vehicle, 529 plans have become the most popular college savings account for Americans.
529 plans have gained favor because some states offer tax deductibility for contributions, earnings grow state and federally tax-deferred, and withdrawals are tax-free as long as the money is used to pay for qualified education expenses.
Prior to 1996, custodial accounts were a popular college savings vehicle for Americans. However, because 529 plans offer greater tax benefits and more control over how the money is spent for the benefit of the child, custodial accounts have become less popular. But that doesn’t mean custodial accounts should be forgotten about.
Custodial accounts, also known as UGMA or UTMA accounts after the Uniform Gifts to Minors Act or Uniform Transfers to Minors Act that created them, are established for the benefit of a minor and managed by a guardian.
Benefits of a Custodial Account
The main benefits of a custodial account are you can take advantage of the gift tax exclusion and manage the funds within the account while your child is still a minor.
Drawbacks of a Custodial Account
The drawbacks are the funds automatically become your child’s once they reach the age of majority (18 or 21 for most states) and investment income may trigger the kiddie tax.
Investing Your Custodial Account Funds
When most people think about custodial accounts, they think of opening a savings account at a local bank. I remember when I was a kid, I had a custodial savings account at the same bank where my parents had their accounts. It was always a cool experience to go to the bank and deposit money I received as a gift for my birthday or Christmas. When I turned 21, the account was transferred to my name and I was surprised by how much I had accumulated over the years.
What some don’t realize is custodial accounts can be opened at a financial institution, like TD Ameritrade or Charles Schwab, where the funds can be invested. By investing your child’s money, you can potentially earn a higher rate of return than letting it grow in a savings account and take advantage of their longer time horizon. The chart below shows the growth of $1,000 invested in a global stock index compared to 1-month U.S. Treasury Bills (a proxy for a savings account) over the last 18 years.
Past performance may not be indicative of future results. Indexes are not available for direct investment. Investing in securities involves risk, including the potential for loss of principal, and is not suitable for all investors.
Of course, the stock market is more volatile than U.S. Treasury Bills, but it offers the potential for much higher returns. This means even small contributions to the account from birthday or holiday gifts can grow into a sum that can be used for a car, college expenses, or a down payment on a house.
If you have any questions about custodial accounts or would like to set up a custodial account for your child or grandchild, please contact a member of the HIGHLAND team.
Author’s Bio
Richard A. Anderson is a portfolio analyst at HIGHLAND Financial Advisors, LLC based out of Wayne, NJ. HIGHLAND Financial Advisors, LLC is a Fee-Only financial planning firm that offers comprehensive financial planning, retirement planning, employer retirement planning, and investment management services to help clients focus on what matters most to them.
Richard graduated from Ramapo College of New Jersey where he earned a Bachelor of Science degree in Business Administration with a concentration in Finance. Richard joined the firm in June 2013 and is responsible for assisting HIGHLAND’s Wealth Advisors in developing portfolios to help individuals, families, and institutions reach their financial goals. He is a Chartered Financial Analyst (CFA) charterholder and member of CFA Society New York. For more of Rich’s thoughts on the markets and sports, follow him on Twitter and connect with him on LinkedIn.