39.5 Custodial Accounts for Minors
A minor generally lacks the ability to manage property. You could create a formal trust, but this step may be costly. A practical alternative may be a custodial account under the Uniform Gifts to Minors Act (UGMA), or the Uniform Transfers to Minors Act (UTMA), which has replaced the UGMA in practically every state.
Custodial accounts set up in a bank, mutual fund, or brokerage firm can achieve income splitting; the tax consequences discussed below generally apply to such accounts. Trust accounts that are considered revocable under state law are ineffective in splitting income.
Although custodial accounts may be opened anywhere in the United States, the rules governing the accounts may vary from state to state. The differences between the laws of the states generally do not affect federal tax consequences.
There are limitations placed on the custodian. Proceeds from the sale of an investment or income from an investment may not be used to buy additional securities on margin. While a custodian should prudently seek reasonable income and capital preservation, he or she generally is not liable for losses unless they result from bad faith, intentional wrongdoing, or gross negligence.
When the minor reaches majority age (depending on state law), property in the custodial account is turned over to him or her. No formal accounting is required. The child, now an adult, may sign a simple release freeing the custodian from any liability. But on reaching majority, the child may request a formal accounting if there are any doubts as to the propriety of the custodian’s actions while acting as custodian. For this reason, and also for tax record-keeping purposes, a separate bank account should be opened in which proceeds from sales of investments and investment income are deposited pending reinvestment on behalf of the child. Such an account will furnish a convenient record of sales proceeds, investment income, and reinvestment of the same.
Income tax treatment of custodian account.
Income from a custodian account is generally taxable to the child. However, if the “kiddie tax” applies (24.2), taxable income from a custodial account in excess of the annual “kiddie” tax floor ($1,900 in 2012) is taxed at the parent’s tax rate.
If a parent is the donor of the custodial property or the custodian of the account and income from the account is used to discharge the parent’s legal obligation to support the child, the account income is taxed to the parent.
Gift tax treatment of custodial account.
When setting up a custodial account, you may have to pay a gift tax. A transfer of cash or securities to a custodial account is a gift. But you are not subject to a gift tax if you properly plan the cash contributions or purchase of securities for your children’s accounts. You may make gifts that are shielded from gift tax by the annual exclusion. The exclusion applies each year to each person to whom you make a gift. If your spouse consents to join with you in the gift, the annual exclusion is doubled. For gifts in 2012, the per-donee exclusion is $13,000, $26,000 if your spouse consents to split the gift (39.2).
If the custodial account is set up at the end of December, another tax-free transfer of up to the annual exclusion may be made in the first days of January of the following year. Assuming the annual exclusion in each year is $13,000, a total of $52,000 can be shifted within the two-month period with spousal consent. The tax-free limit would be higher if the exclusion is increased above $13,000 for years after 2012, as is likely.
Even if gifts exceeding the annual exclusion are made, gift tax liability may be offset by the unified credit (39.4) applied to gift and estate taxes.
Planning Reminder
Estate tax treatment of custodial account.
The value of a custodial account will be taxed in your estate if you die while acting as custodian of an account before your child reaches his or her majority. However, you may avoid the problem by naming someone other than yourself as custodian. If you should decide to act as custodian, taking the risk that the account will be taxed in your estate, remember that no estate tax is incurred if the tax on your estate is offset by the estate tax credit.
If you act as custodian and decide to terminate the custodianship, care should be taken to formally close the account. Otherwise, if you die while retaining power over the account, the IRS may try to tax the account in your estate.