Interest paid on a minor's account is taxable. However, people younger than 18 seldom earn sufficient income to create tax problems, so it rarely matters what types of accounts they have. Two primary account options for minors exist. One is custodial savings accounts in banks or credit unions. Option two is state-sponsored 529 college savings accounts for minors. Some 529 plans offer state tax deductions for contributions to these accounts.
When you open a custodial account -- also called a Uniform Gift to Minors Act account, or UGMA account -- you provide the bank or credit union the child's Social Security number. The interest earnings are taxable to the child. However, because most children earn less than the typical IRS minimum to pay taxes, few minors have income tax liability. You are the custodian making deposits, but the account belongs to the minor.
529 Education Savings Plans
These accounts, while similar to custodial accounts, are legally different for at least two reasons. The account must be used for higher education tuition and qualified expenses to get tax benefits. And the interest earnings are not subject to federal taxes. Some of these state-sponsored accounts also offer state tax benefits for your contributions or your earnings. The minor is not taxed while the account is building up. If you used the balance for other than educational expenses, you -- not the minor -- would be taxed on the earnings. You'd also pay a 10 percent federal penalty on these earnings.
Minors' Tax Issues
Minors can receive unearned income, such as interest, of up to $950 before needing to file a tax return. Minors earning more than $950 in interest must file tax returns, but they often aren't subject to any income tax. If any income tax was withheld but the minor earned less than $950 in interest, she should file a return to get a refund. Minors are legally responsible for filing their own returns, but a parent can file if the child can't because of age or any other reason.
Although all standard custodial accounts for minors receive taxable interest, the timing of when you open the minor's account might have income tax consequences. Opening a custodial savings account for newborns or toddlers seldom brings tax concerns for numerous years. However, opening an account for a teenager, particularly if the teen works, can create income tax liabilities in the near future. IRS regulations differentiate between unearned income, such as interest on a minor's account, and earned income, such as from wages. Minors with both earned and unearned income sometimes owe taxes.