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Often called UGMAs or UTMAs, after the Uniform Gifts to Minors Act and the Uniform Transfers to Minors Act, these custodial accounts let you set aside money or other assets in a trust for your minor child. As trustee, you manage the account for your child until he or she reaches the age of majority18 or 21, depending on the state. You can withdraw the money to use for the benefit of your child, but you can't take it back.
Custodial accounts once served as a way for parents to shift the tax on earnings from their own higher rate to their child's, but a change in the law has greatly restricted that strategy. In 2010, children who are full-time students under age 24 pay no tax on the first $950 of investment earnings, and they pay the child's (presumably low) rate on the next $950. Earnings above $1,900 are taxed at the parents' marginal rate. (That trigger point may increase.)
Custodial accounts carry no limits on income or contributions (although annual gifts over $13,000 or $26,000 from both parents can raise gift-tax issues), but they can have a significant impact on your student's chances for financial aid because the federal financial-aid formula assesses 20% of student-owned assets, as opposed to up to 5.6% of parents' assets. You can, however, cash out the account and transfer the money to a 529 plan, where it will be treated for financial-aid purposes as a parental asset.