Play Dough
Year-End Planning
December 3, 1997

Inveterate readers of the Family Fool will recall that in a recent article on investing for college, we mentioned some tax advantages that come with custodial accounts.

As Santa puffs his merry way toward us, as Father Time turns another page in the book of years, we shine the blinding light of our collective intellect back upon the subject of kids and taxes.

"UGMA" -- What is that grunting noise?

How does a custodial account work, anyhow?

The account is held in the name of the parents, who are custodians for the kids. Legally, the assets held in the account belong to the kids, but the parents actually control the account. This is to prevent financial ruin, such as may occur when your four-year-old decides to order $16,000 worth of gummy bears. So, in effect, the parents have control until age 18 (or the age of majority in the state). Of course, by this time parents may have lost control of just about every other aspect of their child's life, so this is at least one solid tent peg in the storm. It's all generally done under the Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA). These acts have nothing to do with uniforms.

Remember that from age 1 to age 13, the first $650 of investment income in one year is taxed at ZERO. The next $650 is taxed at the child's rate (generally 15%). Anything over $1,300 will be taxed at the parents' rate. (These amounts will increase in the future, pegged to inflation.) So if you can control the account so that no more than $1,300 in investment income is generated in a year when the child is age 1 to age 13 (investing in non-dividend paying growth stocks or mutual funds, and only realizing a minor amount of sales, gains, interest, etc.) you can have a very powerful method of saving money AND avoiding tax at the same time. And best of all, IT'S ABSOLUTELY LEGAL!

Once the child reaches age 14, the first $650 is not taxable, and any amounts greater than $650 will be taxed at the child's rate. This doesn't sound like much of a deal, but remember that the 15% rate will reach all the way up to taxable income of about $24,000 for a single person. The tax on $24k at 15% amounts to $3,600. If mom and dad are at the highest bracket, their tax on this same $24k would be closer to $9,500... or a savings of $5,900 in tax per year. BIG NUMBERS.

We Are Not Shifty

Obviously, if mom and dad are in the 15% bracket themselves, it makes no sense to do any of this...since the tax paid would be the same from either party. What we are doing above is called "shifting" in the lingo of tax. We want to "shift" taxable income from someone in a higher bracket to someone in a lower bracket -- but within the family.

This is really nothing new. It's been around for years, and is not just limited to kids. Elderly parents who survive on limited funds can also be prime candidates to whom income can be shifted.

--David Wolpe (TMF [email protected])and Roy Lewis (TMF [email protected])

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