The rules for custodial accounts can vary somewhat from state to state, but one factor that remains pretty consistent: taxation. The Internal Revenue Service and the federal government have some firm rules and requirements when it comes to the income a custodial account earns. Your child is liable for any resulting taxes, although in some cases you can step in and assume responsibility yourself.
When you establish and fund a custodial account for your child – either an UGMA or UTMA account – it’s a gift you can't take back. Your child is legally the owner of the account. Her Social Security number is associated with it – not yours. Your only role is to manage the account for her until she reaches the age of majority. At that point, you relinquish all control and she takes over. She can do anything she likes with the money.
Because your child technically owns the account, she's the one who pays taxes on its growth – but this isn't quite as cut-and-dried as it sounds. The first $950 per year is tax-free as of 2012. The IRS taxes the second $950 at your child's tax rate, which is typically minimal. If the account exceeds $1,900 in growth in a given tax year, things begin to get complicated. Your own tax bracket now comes into play.
The Kiddie Tax
Even though the growth is your child's income and the IRS taxes her, not you, she'll pay taxes at your rate on anything over $1,900. This wrinkle is known informally as the "kiddie tax." It prevents parents from placing income and investments in their children's names to avoid the IRS taking a tax bite at their higher taxrates. If your child's custodial account generates $4,000 in income during the tax year, $950 is tax-free, $950 is taxed at her rate – which might be as low as 10 percent – and $2,050 is taxed at your rate.
Under some circumstances, you can save yourself the aggravation of having to prepare a separate tax return for your child by claiming the income from her custodial account on your own return. It probably won't save her tax dollars – in fact, you'll pay additional taxes on that extra $950 that otherwise would have been taxed at her rate. The option is a matter of convenience more than anything else, and it's not available to all parents. You can only do this until the tax year in which your child turns 19, or 24 if she's a full-time college student, and only if her investment income doesn't top $9,500 as of 2012. If she's a teenager and she also holds down a job and earns income, she must file her own return as well. Depending on the amount of her unearned income, claiming it yourself could push you into a higher tax bracket – increasing the percentage at which both your income and her custodial account's growth are taxed – so make calculations both ways at tax time to determine your best option.