School Daze, or Why Setting Up a Custodial Account for Your Kid Isn't Such a Hot Idea

Sending Biff or Caroline to school is no mean feat. Though the rate of increase in college tuition and board has slowed in recent years, it is still well above inflation and probably above your raise.

Many tax advisors urge proud parents to set up custodial accounts for their kids as a way to avoid the clutches of the IRS. It's true that you can save taxes by setting up these accounts but it's not a magic potion either.

If you set up a custodial account, which virtually all mutual funds and brokers allow, you don't pay any tax on up to $650 of investment earnings if your child is under 14. The next $650 is taxed at 15 percent and gains above $1,300 are taxed at the parents' rate. Once your kid is 14, the federal rate goes up, usually to 15 percent on all income.

If the child is young, most of the custodial account should be in stocks or stock mutual funds, given that the funds won't be used for 10 to 15 years. But unless you're invested in utility stocks, your annual dividends may not amount to $1,300 or even $650 and you'll be forced to play short-term trader--buying and selling stocks to get enough capital gains to max out.

If you buy stock mutual funds, you're in an equal quandary; many funds have significantly different distributions of income and capital gains from year to year and again, you may be under the limit.

While investors can choose bonds to get the most steady income, they generally have a lower, long-term return and may not yield enough to pay for four years at Sarah Lawrence or even at the University of Alabama.

Another problem with custodial accounts is that colleges want to see you take every penny out of them to finance your children's education. Under most financial aid schemes, universities want kids to spend 35 percent of their income each year while parents are expected to shell out only 6 percent.

For some parents, it's simply more convenient to pool all investment funds and pay the higher rate.

For others, the best thing to do is to keep the custodial accounts until the child is in his or her teen years and then transfer the funds to the parents' account. That way when it comes time to fill out the financial aid forms, junior will be cash poor and more eligible for help.

Bottom line: custodial accounts can save money for parents willing to do the work. For those who aren't, just keep it in your name.

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