Using custodial accounts to hold assets for children is simple, inexpensive, and effective for income tax savings. There are drawbacks, though:
Loss of control: Custodianship ceases when a child attains the age of majority, which is between 18 and 21, depending upon state law. At that point, the youngster automatically acquires control over any assets in these accounts. Money intended for college may be used to buy a sports car.
Financial aid failure: Transfers to custodial accounts work against families who apply for college financial aid.
Estate tax turnaround: If a parent acting as custodian dies while the account is still effective, the account’s assets may go back into the decedent’s taxable estate and increase the estate tax obligation.
Support obligations: Depending on state law, custodians may run into a tax trap if they tap a custodial account for items they’re obligated to spend as a parent. If you tap your daughter’s bank account to pay for her school clothes, for example, the IRS may say that the custodial account really was used for your benefit so the taxable income generated by that account should be reported on your tax return.
If any of these issues are a major concern, you might want to avoid placing large amounts in a child’s custodial account.