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How Custodial Accounts Are Taxed

Investment income of more than $2,000 a year is taxed at the parents’ rate. If you plan to use the money for college, a 529 savings plan is a better way to go.

I read your Get the Kids Started in Stocks column and had two follow-up questions: How are children’s custodial accounts taxed? Do I need to use the account for educational expenses?

SEE ALSO: 7 Smart Ways to Pay for College

Custodial accounts -- also called Uniform Transfers to Minors Act or Uniform Gifts to Minors Act accounts -- have fewer tax advantages than they did in the past. Now, the first $1,000 of the child’s investment income is tax-free, and the next $1,000 is taxed at the child’s rate (often 10%, which is the lowest income tax bracket). Investment earnings above $2,000 are taxed in the parents’ bracket until the child turns 19 (or 24 if the child is a full-time student). In the past, the child’s rate would apply after he or she turned 14. See the Instructions to IRS Form 8615 for the calculations.

You can use money from the custodial account for educational expenses, but you can also use it for other expenses to benefit the child, such as travel, camp, tutoring or a computer. When the child reaches the age of majority (usually 18 or 21, depending on the state), he or she gets full control of the money in the account and can use it for anything -- one of the biggest drawbacks of custodial accounts.

Opening a custodial account for your kid can be a great way to teach him or her about investing. But if you plan to use the money for college costs, a better alternative tax-wise is to contribute to a 529 college-savings plan. Money from a 529 plan can be used tax-free for tuition, room and board, and other expenses. Your 529 contributions may also be tax-deductible, depending on your state, and you can change the beneficiary to another family member (custodial account contributions, by contrast, are irrevocable).

See The Best 529 College-Savings Plans for our top picks. Another option for education expenses is a Coverdell education savings account, which can be used tax-free for college as well as certain educational expenses for kindergarten through grade 12. See Tax-Free Savings for Precollege Education Expenses for details.

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