Advantages
In tax year 2009, for children younger than 18, the first $950 of unearned income is tax-free. The next $950 is taxed at the child's federal tax rate. Any earnings over $1,900 are taxed at the custodian's federal tax rate. To learn more about the tax rules for children, you should read IRS Publication 929: Tax Rules for Children and Dependents.
As with ESAs, your investing options are virtually limitless. Nor are there any contribution or income limitations. In addition, withdrawals can be used for any purpose, not just qualified education expenses, without penalty.
Disadvantages
When your child reaches the age of majority—18 to 25 depending on the state in which you live—he or she takes control of the account and can use the money in the account for anything. Because you lose control over how the money may be spent, some parents and grandparents may not like this option. Another potential disadvantage is that because the account is considered the child's asset, you can't switch beneficiaries. So if your child decides not go to college or gets a scholarship, you can't switch the money to a brother, sister or other family member.
| Tax-Free Transfer to a 529 Plan. You now can transfer funds from a custodial account to a 529 plan if the plan accepts such transfers. However, you must liquidate any investments you have made in a custodial account because you can only transfer cash and pay taxes, if any, on any gains. Another problem with transferring custodial account funds is that the money is the child's asset, not yours, so you cannot transfer the 529 plan to another beneficiary. There also may be other restrictions and limitations. |
