Tuesday, May 28, 2013

Bank Accounts, Savings for Kids & Tax Consequences

Picture Courtesy: pbskids.org
When my 13 year old got her first baby sitting check, a range of emotions ran through me. I was happy, proud as a mother hen could be and also a little worried as I thought of how my "baby" was so grown up that she could take care of other "babies"! As she made plans to deposit that money in her UGMA Bank Account, I realized I had an idea for my next blog post! 

Like I said, my kids like any self-respecting accountant's children, were equipped with UGMA Accounts at a tender age. It's never too early to start saving, I find that it's also never too early to start teaching about the importance of being financially responsible! It can however be a little overwhelming when trying to decide what account to open for your child. Here are some pointers which will hopefully help you decide: 







Picture Courtesy: Google Images

Joint Accounts These are the simplest to start with. One can open a bank account jointly with your child. Both the parent and the child will have access to the money and the account statements. This account remains in joint custody till either party indicates otherwise to the bank. 



Custodial Accounts Most commonly known as UGMA Accounts or Uniform Gift to Minors Account are custodial accounts. These are very popular. Under federal law, minors-in most states those under age 18-cannot open bank accounts in their name alone, unless it is a custodial account. This means a "custodian" or an adult is in charge of or manages the account for the minor until he/she reaches majority. The money in this account is considered the minor's property & cannot be withdrawn for the adult's benefit. And it can be converted into a regular savings account once the child stops being a minor. 



Picture Courtesy: accumalatingmoney.com

A 529 Plan/ Education Savings Plan This plan gets it's name from section 529 of the Internal Revenue Code, it allows you to save for your child's education. The major advantage of this account is tax savings. The earnings grow tax deferred in this type of account. The earnings, withdrawals & distributions  are never taxed for any federal tax purposes as long as they are used towards eligible college expenses. However, be wary that if the money is withdrawn & used for purposes other than education/ college expenses, you will be subject to federal income tax & an additional 10% federal tax penalty on the earnings.

 

A POD Trust or a Totten Trust This is a very simple trust that can be formed without recourse to expensive lawyers or drawing up a formal trust document. An adult can draw up this trust & name a child as a beneficiary. This is an easy way to avoid probate costs at death. The child however does not have access to funds till the death of the owner. 


Tax Consequences 

The amount of tax payable for a child's account depends on these events for federal tax purposes: (A) Incidence of Ownership; (B) Type of Income; (C) Amount of Income.

(A) Incidence of Ownership To the extent the child owns the account, he/she is responsible for reporting the income if required. If the child was only a beneficiary of a trust, then he/she is not responsible for reporting income, it is to be reported by the owner of the trust. 

(B) Type of Income There are 2 types of income; Earned- which includes wages, tips & salary AND Unearned-which includes dividends and interest from bank & brokerage accounts. The rules for reporting earned/ unearned income alone are straightforward  however if there is a mix of the 2 then it may get complicated. (See Pub 929 for more information.)

(C) Amount of Income For the tax year 2012, if your child is below 19 years of age or is below 23 & is a full time student, the first $950 is tax-free; the next $950 is taxed at the child's rate; any unearned income above the combined amount, $1900 (950+950) is taxed at the parents' rate, also known as "Kiddie Tax".  


No matter what the tax consequences are, consider what you want to achieve when making decisions to save for your kids. Do you want to teach financial responsibility? Do you want to save for a rainy day? Or do you want to put money away for college? Make the best decision in consultation with your tax advisor who has knowledge of your unique situation. 

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Please read my disclaimer here. Please contact me at manasa@mntaxsolutionsllc.com for more tax questions.