MaineNewsDirect.com

Have a Custodial Account in Your Child’s Name? Beware of this

Last year, Congress blindsided those who set up custodial accounts in their children’s name. Well it looks like Congress is up to their tricks again.

In pending legislation, a provision was added to the Small Business Tax Relief Act of 2007 (H.R. 976) to discourage the practice of transferring investment assets to a child for the purpose of avoiding the parents’ higher tax rates. The new rules would apply retroactively to all sales that occurred after December 31, 2006. This provision increases the age threshold in the Kiddie Tax from under-18 to under-19 (and under-24 if a student). If a child under the age limits has unearned income in excess of $1,700, the excess is taxed at the parent’s rate.

Over the years many parents used custodial accounts to help save for their children’s education or fund other goals. These accounts have the parent as the custodian while the account is titled in the child’s name. In most cases these are known as UTMA or UGMA accounts. These accounts are mildly tax advantaged due to the “kiddie tax” rules. Under the current rules, if the child is under age 18, the first $850 of annual investment income is tax free, the next $850 is taxed at the child’s rate and anything beyond $1,700 is taxed at the parent’s rate. If played right, there would be many cases where the parent wouldn’t need to pay any tax at all or just the child’s lower rate. After age 18, income above $1,700 would be taxed at the child’s rate.

When the rules were changed last year where the “kiddie tax” age increased from under 14 to under age 18, this created several problems. Many parents who accumulated a good portion in these accounts for college usually planned to sell their high growth assets for more conservative assets when the child reaches age 14-18; lowering the risk of a market decline in the leading years before the child goes to college and incurring a capital gain at the child’s tax rate. The new rule has many parents caught in the dilemma between paying more in taxes by shifting the portfolio in a more conservative manner or “taking their chances” and sell once the child reaches age 18; hoping the stock market doesn’t take a tumble in the meantime. The change really diluted the effectiveness of using a custodial account and polarized the other options available. Saving for college costs? Now a Coverdell or a 529 Plan is most likely your best option.

Now this new pending legislation would cause another problem. If the custodial account was used for college costs, now the “kiddie tax” rules would apply if the account owner was a student under the age of 24. After last year’s changes, if the parent decided to “take their chances” and sell once the child turns 18 for college costs, then this new legislation kills that approach unless you want to defer liquidating until after the child turns 24 (and take your chances with the market for several additional years). And if you decide to hold, there are problems with this as well beyond investment risk. Since the account is considered an asset of the child, this can potentially lower their potential for college aid eligibility. Talk about in between a rock and a hard place.

What if you already have funds in a custodial account? If you are in the situation described above, you really have to decide if rebalancing the portfolio is worth the cost of the increased tax. If you have just started out, it may prompt you to sell the custodial account and place it in a custodial 529 plan. Many 529 plans allow for custodial ownership; you may have to pay taxes on gain in the regular custodial account when you liquidate, but it may be worth taking a one time tax hit for future tax free earnings if used for qualified education costs.

Although this is still pending, individuals with these types of accounts should be aware of this and plan with this in mind.

E-mail this entry to a friend