This is a type of custodial account set up in a child’s name by their parent. This is necessary because parents are not allowed to simply shift assets over to their minor children. By setting up this special trust a parent is allowed to basically “gift” the money to the account. Even though the child’s name is on the account they are denied access until they are of legal age (either 18 or 21, depending on the state in which they live).
This is done to ensure that the money is safe and securely invested for the time when college tuition becomes an issue. The danger with this account is that once your child does reach legal age, they assume all control of the money within the account. Legally speaking, a parent then forfeits their right to impose that their now adult child spends that money on a college education.This can be a problem if your 18 year-old decides that the money would be better spent on a backpacking trip around Europe.
Another downside includes the fact that because the money in the account is considered to be the asset of the adult child, this can have major implications in the pursuit of additional financial aid. On the upside however, a UGMA account costs nothing and are relatively easy to set up. Also, parents and other family members, including the children themselves, are allowed to contribute up to $10,000 annually without having to pay a federal gift tax.
An Education IRA
This is another option for parents to look into. Similar to a standard individual retirement account, it allows parents to contribute money for each child they have under the age of 18. Although the contributions made to this account aren’t tax deductible, parents will avoid having to pay taxes on the total amount within the account as long as the money is eventually spent on such things as tuition, books, room and board, and other college related expenses.
The nice thing about this account is that if the money hasn’t been withdrawn and used for any college related expenses by the time a “child” has reached the age of 30, the money can be rolled over to the education IRA of another family member. If this is not an option, the money within the account would then be considered taxable and also subject to a 10% penalty.
One of the disadvantages to this type of account is that there are strict income limits as to who will qualify. Also, individuals are seriously limited to the amount of money they can contribute each year. This means for all your contributions, there’s a very real possibility that you still won’t have enough to finance your child’s education.