One of the most frequently asked, and misunderstood, questions in all of the tax preparation business is “What is the best way to save for a child?” What savings option will create not only the biggest savings for the child, but also the biggest tax benefit for the one putting the money away? This question is so often misunderstood because it involves examining three separate decision-making areas:  income tax decisions, estate tax decisions, and financial control choices.

First, let’s review ways you can save on behalf of a minor. There are three main ways:  1) in a custodial account for the minor 2) in a trust or 3) in your own name.  Each choice has its own advantages and disadvantages.  However, each option shares a common denominator: an attempt to shift income and assets in a favorable way for both income tax and estate tax purposes.

There are some critical factors to consider before deciding on what the best option is for you and for the minor. These considerations include: How old the child is, what amount of savings is at stake, how long the savings plan will be in effect, and how much you trust the minor to act responsibly when the age of majority is reached.


Putting the savings legally in a minor’s name can result in some or all of the income being taxed at the lower rate of the minor and can move some of that income away from the tax return of the person who funds the account. A Custodial Account also separates the ownership of the funds in the account from the contributor, making the funds the property of the minor.

The simplest way to transfer money and other financial assets to a minor is by using an account created under either the Uniform Gifts to Minors Act (UGMA) or the more recent Uniform Transfer to Minors Act (UTMA).  Basically, both these methods involve gifting over money to the child and appointing a custodian to manage the funds. (The custodian can be any adult including yourself.)  These accounts are easy to set up with a bank, brokerage company, money manager, or the like.  In order to establish either of these accounts the child’s social security number must be used. This is because the money is legally the child’s money the minute it goes into the account and is therefore taxable to the child.

There are a few differences between the UGMA and the UTMA that should be noted.  A UGMA account automatically gives control of the funds to the child at the age of 18. A UTMA account can delay this until age 21, or, depending on state law, as late as age 25.  Another benefit of using a UTMA is the increased number of savings options. Using a UTMA allows the custodian to purchase real estate and royalty producing investments, among other things, which are not allowed under the older UGMA laws.

Every state except for Vermont and South Carolina has adopted the newer UTMA law. However, because of the ever-changing legal landscape, it is always best to discuss your options with a professional before making any new account.


One of the main advantages of using a custodial account is that funds are able to escape being included in the donor’s estate and can, therefore, escape estate taxes. Another benefit is the ability to shield the money from any lawsuits in which the donor is involved.  The income generated by these savings accounts is taxable; however, the tax is assessed to the minor, which can result in significant savings if the tax bracket for the donor is higher than the minor child’s tax bracket.

However, depending on the situation, some of that income could be subjected to the “Kiddie Tax,” which is the common name for the “Tax on a Child’s Investment and Other Unearned Income.” This forces unearned income in excess of a preset threshold to be taxed at the parent’s tax rate instead of the child’s. (This is discussed in more detail below.)

Another positive is that custodial accounts are very easy to set up, with no fees and no lawyers required.  Moreover, depending on the yearly earned and unearned income of the child, the child may or may not need to file a tax return.


One of the main complications from an income tax standpoint is the problem of the so called “Kiddie Tax.” In effect, it can require a child up to 23 to pay the greater of their own tax rate or their parent’s tax rate on “unearned income” (investment and interest income). Under the 2017 IRS rules, if the child is under age 18, (up to 23 if they are a full-time student and parents provide more than 50% of their support) and has unearned taxable income over $2,100, the child could be subject to the “Kiddie Tax.” The child pays a tax on unearned income at a rate the same as the parents’ on all the income exceeding this $2,100 figure. A word of caution: the “Kiddie Tax” can be complicated and only becomes more complex when multiple children and accounts are involved.

The “Kiddie Tax” can make custodial accounts far less attractive if the main objective of the account is to move unearned income, thereby reducing the tax on it from the parent’s tax rate to the child’s tax rate. The “Kiddie Tax” makes this type of planning much more difficult as income and tax thresholds need to be calculated and carefully considered. In some cases, it may make more sense to consider investments that generate tax-free income or have capital gains potential instead. This can avoid creating income that will still be taxed at the parent’s rate.

Another drawback of custodial accounts is that the money is legally the child’s from the moment you gift it; when the child reaches the age of majority, the child can do whatever they wish with the money -– even buy a Harley Davidson –- and there is nothing you can legally do to stop this.  So you should have a good sense of trust in the child’s future judgment when you set up a custodial account.


There are several types of trusts you can set up, but the most common for the purpose of child savings is the 2503(c) trust, nicknamed the “minors’ trust.” This type of trust can be complicated and expensive to set up. Creating a 2503(c) usually requires hiring a lawyer.  In addition to the high costs of establishing the trust,  it can also be expensive to maintain since a yearly tax return must be filed (Form 1041). Form 1041 can be quite involved and is usually expensive to have prepared.

However, using a trust may have certain advantages.  First, the trustee can exercise much more control over the money and control the money much longer if the trust is set up properly.  In effect, a trust can be structured so that the trust can continue long after the child reaches age 21, thus keeping the donor in control of the principal. Second, the money in the trust can be shielded from the donor’s liability in event of a lawsuit.  Finally, it allows for far more sophisticated estate tax planning avenues.


Saving in your own name is a viable choice as well.  Although the tax savings may be less if your tax bracket is higher than your child’s, you retain complete control over the funds.  When the time comes to use the money for the child (often for education), you can gift the money over time in payments. As long as the annual gift amount is $14,000 (adjusted annually for inflation) or less, per person, you have no gift/estate taxes to worry about.  A husband and wife can jointly give $28,000. Also, you can make direct payments to the child’s educational facility (instead of giving it to the child) without any dollar amount restrictions for gift tax laws.

The disadvantages are twofold.  First, the money is considered part of your estate, so at death, it may be subject to estate taxes.  (This is only a problem for those with estates that are greater than $5.49 million in 2017.) Second, if your tax bracket is higher than your child’s with the same type of investments, you may pay more taxes if they are in your name than you would in a trust or custodial account.

Of course, a way to get around the higher tax problem is to use investments that don’t produce ordinary taxable income.  Naturally, you should go over these possibilities with an investment or financial advisor. Some of these alternate investments include: growth-type investments that appreciate in value (instead of paying interest or dividends on stocks, real estate, etc.); stocks with qualified dividends and long-term capital gains, which are taxed at a lower rate than ordinary income; tax exempt bonds, tax deferred bonds (e.g. Series EE Savings Bonds); certain tax-deferred annuities; and company sponsored pre-tax savings plans.

In effect, you can minimize, or optimize, your income tax rate while still retaining control and ownership of the investments.

Bottom Line

Using a trust makes sense if the investment in question will be generating a large enough amount of taxable income before the minor is age 24 to justify the extra costs of both setting up the trust and operating it.

Moreover, the difference between the parents’ tax bracket and the trust’s must be sufficient enough to justify the increased costs.  If you are a typical parent, saving an average amount for your child, the probability is that this 2503(c) trust would not be the first choice from an income tax saving standpoint.

For most, depending on the circumstances, either a UGMA or UGTA provides the biggest tax savings while leaving the savings in your own name allows for the greatest degree of control.

Each option carries with it both strengths and weaknesses.  However, the more you feel you can trust your children, the higher your tax bracket, and the better you can predict the taxable yields on the investments used, the more favorable a Custodial Account could be.  But if you cannot adequately guarantee they will use the money for its intended purpose when they reach the age of majority, think twice about using a Custodial Account!

The best advice we can give is this: before taking any action always consult your tax professional. A knowledgeable tax professional can help you work through the costs, the benefits, and the tax consequences of saving for your children, thereby assisting you with developing a plan that is best for you and your family.


© RMS Accounting 7/14/2017