Creating accounts for kids: Practical and tax consequences

It’s never too early to start saving. Opening a bank or other investment account for your child can be a great way to help her save for the future while teaching the importance of being financially responsible.

Under federal law, minors cannot open savings accounts in their own name alone. However, a minor can open a custodial account. A custodial account is technically the property of the minor but is managed by an adult, often referred to as a custodian, until the age of majority. Since the money inside of the account is considered the minor’s property, a custodian may not make withdrawals for his or her own benefit. When the minor reaches adult age, the account can be converted into a regular savings account. The most common kind of custodial account is a UGMA account, or Uniform Gift to Minors Act account.

In some states, a minor may own a bank account jointly with an adult. In that event, both the parent and the minor will have access to the account and the account statements. Unlike a custodial account, the money is owned jointly and does not become the property of the minor at a certain age; it remains in joint names until the account owners indicate otherwise.

A Totten trust is a very simple kind of trust that doesn’t require a formal trust document. A Totten trust, also called a POD account, allows an adult to name a beneficiary, including a child, for the account. It’s an easy way to avoid probate costs at death but isn’t a terrific way to teach a child about money since the beneficiary of the account doesn’t have access to the funds until the death of the owner.

A 529 plan, sometimes referred to as an education savings plan allows you to save for your child's education. The plan takes its name from section 529 of the Internal Revenue Code which is appropriate: The main benefit of the plan is the tax savings. Neither the earnings from the investment nor the distributions or withdrawals from the plan are taxable for federal income tax purposes. Those investments grow tax-free and are never taxed for federal purposes so long as you use withdrawals from the investments for eligible college expenses, which includes most costs associated with college like tuition and room and board as well as fees, books, supplies and equipment. However, if you withdraw money from the plan for a purpose other than eligible college expenses, you will be subject to federal income tax and an additional 10 percent federal tax penalty on earnings.

For federal income tax purposes, the amount of tax payable for a child’s account depends on three factors: The incidence of ownership; the type of income and the amount of income.

The first piece is easy. To the extent that the child owned the account, the child is responsible for reporting the income, if required. To the extent that the child was merely a beneficiary of the account , the child is not responsible for reporting the income; that responsibility falls on the owner.

The second piece is also easy. Dividends and interest from banking or brokerage accounts are considered unearned income . The rules for reporting unearned income are quite straightforward. If there is a mix of earned and unearned income , the rules can be more complicated: Check IRS Pub 929 for more information.

Finally, the amount of income comes into play. For the 2012 tax year, children under the age of 18 or children under the age of 23 who are full-time students treat the first $950 of unearned income as tax-free income; the next $950 is taxed at the child’s rate. Unearned income over those combined amounts, $950 + 950, or $1900, is taxed at the child’s parents’ tax rate. That’s the amount often referred to as the “kiddie tax.”

All of that said, don’t get wrapped up merely in the tax consequences when making your decision about the best way to save. Consider your end goals. Are you trying to teach financial responsibility? Save for a rainy day? Pay for college? The answer to those questions, combined with the tax consequences will help you make the best decision for you and your child.

More about family finances

The new tax picture in 2013
Claiming dependents on your taxes
Tax consequences of gifts to kids