Custodian accounts: An easy way to save on taxes

A previous column discussed how investors with long-term capital gains from the sale of stocks and other assets could reduce their taxes. The top tax rate was cut to 15 percent for individuals in the four highest income tax brackets, 25, 28, 33 and 35 percent, and to 5 percent for those in the two lowest brackets, 15 and 10 percent.

Parents and grandparents in the 25 percent or higher brackets ought to think about transferring appreciated assets to their lower-tax-bracket children, grandchildren and other family members. Before plunging ahead, though, gift givers should be aware of the ?kiddie tax? rules. Those rules generally tax children under the age of 14 at their parents? top rate for investment income from interest, dividends, capital gains and other kinds of ?unearned income? that exceeds a specified amount that is adjusted yearly to reflect inflation. For the tax years 2004 and 2005, the amount is $1,600. Gift givers also need to consider the paperwork. Making gifts to minors mandates the use of custodial accounts, the primary vehicles employed to shift ownership of securities to children, or ownership must be placed in other kinds of arrangements, such as trusts or guardianships.

Most parents avail themselves of custodial accounts, which come in two flavors?those under the Uniform Gift to Minors Act (UGMA) or those under the Uniform Transfer to Minors Act (UTMA). Parents like UTMAs, used by most states, and UGMAs, because these accounts provide inexpensive and easy ways to irrevocably transfer assets to children without the bother and often substantial, ongoing expense involved in the creation and maintenance of trusts.

While UTMAs have their advantages, they also have some drawbacks that cause many parents to shun them. One potential disadvantage is that the parents? custodianship ceases when the child attains the age of majority, between 18 and 21, depending upon the state?s law. That is, when the son or daughter automatically acquires control over the assets, funds squirreled away in a UTMA for college can instead end up being used to buy a Harley-Davidson motorcycle. Not surprisingly, the mere possibility of this?or worse?causes many parents to be more comfortable with trusts that allow them to keep way more strings on how and when a youngster gets hold of the property.

Assume a parent puts property in a UTMA for a child younger than 14. By the time of the appreciated property?s sale, the child is older than 14 and is in an under 25 percent income tax bracket. The capital gains rate is 5 percent for a sale through 2007. Better yet, a sale in 2008 will completely sidestep taxes. In whichever year the sale occurs, this strategy is a swell way to help swell a fund, whether created for college or graduate school costs, the down payment on a starter dwelling, or the inauguration of an investment portfolio, to cite just some of the uses the money could be put to.

For example, Mom owns shares of stock acquired more than a year ago at a cost of $15,000. The stock is now valued at $20,000. Were she to sell them this year, a $5,000 gain taxable at 15 percent would add $750 to her tax bill. Instead, she gives the shares to Junior, her 15-year-old son. As donor Mom?s holding period and original cost of $15,000 both carry over to Junior, his long-term gain on a later sale is the selling price?s excess over $15,000. A $5,000 gain taxable at 5 percent boosts his tax bill by $250 at most and less than that if the gain is his only income. Thus, he receives $500 more than if she had sold the shares and given the proceeds to him. In other words, more remains within the family as a unit.????????????????????

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