The Uniform Transfer to Minors Act allows parents to create special custodial accounts for their children. Those accounts are subject to the kiddie tax. The kiddie tax is a set of special tax rules designed to dissuade a parent from transferring investments to his children to take advantage of his children's lower tax bracket.
UTMA/UGMA Account History
When the Uniform Gifts to Minors Act (which has been updated by UTMA in most parts of the country) was first passed, parents could transfer money into special accounts for their children. Money in a UGMA/UTMA account stayed under the parents' control for the benefit of their children and passed over once the children reached the age of majority. Since kids usually earn less than their parents, the money in the account was subject to less tax than money that the parents held, so many parents shifted as much of their investments as possible to their kids.
The Kiddie Tax
To prevent parents from putting money in their kids' UGMA/UTMA accounts just for tax avoidance purposes, the IRS instituted the kiddie tax. As it is configured in the 2013 tax year, children get a $1,000 standard deduction that they can use to make their $1,000 of investment tax-free. The next $1,000 of investment income is taxed at their income tax bracket, and anything over that gets taxed at their parent's tax rate. To the IRS, childhood lasts until age 19 or until 23 if the child is a full-time student that isn't earning enough to provide at least half of his own support.
UTMA/UGMA Account Strategy
Bearing in mind that your children will have to pay your income tax rate anyway, it doesn't make a lot of sense to put too much income in their names. As such, if you choose to open these accounts for your child, you might only want to fund them to the extent that you take advantage of your child's kiddie tax exemption. If your child earns more than $2,000 per year of interest or capital gains (as of 2013), he's going to pay the same taxes as you, so giving him the money makes little sense from a tax perspective.
UTMA Accounts and College
If you're planning on using the account to pay for your child's college education, a section 529 savings plan may be a better choice. First, money in a 529 plan accrues tax-free, so you won't have to worry about any tax -- kiddie or otherwise. Second, most financial aid offices treat 529 plans much more kindly than UTMA accounts. If your child has money in a UTMA account, the financial aid office will count 20 percent of its balance against your child. Money in a 529 plan gets treated as a parental asset, and only 2.6 to 5.6 percent of those are counted against your child's financial aid award.
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