Bank accounts for kids: An easy guide for moms

Opening a bank account or another investment account for your child is one of the most effective hands-on ways to teach financial responsibility. And as the saying goes, it’s never too early to start saving. Once your child has the concept of money down, opening their own bank account may be the next logical step.

But when it comes to figuring out which kind of account to open for your child, it can be a bit overwhelming. Here’s a quick walk-through of some of the options that are available.

Custodial account

Under federal law, minors (generally, those under the age of 18 in most states) cannot open savings accounts in their own name alone. However, a minor can open a custodial account. A custodial account is technically the property of the minor but is managed by an adult, often referred to as a custodian, until the age of majority. Since the money inside of the account is considered the minor’s property, a custodian may not make withdrawals for his or her own benefit. When the minor reaches adult age, the account can be converted into a regular savings account. The most common kind of custodial account is a UGMA account, or Uniform Gift to Minors Act account.

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Joint account

In some states, a minor may own a bank account jointly with an adult. In that event, both the parent and the minor will have access to the account (yes, that includes the money) and the account statements. Unlike a custodial account, the money is owned jointly and does not become the property of the minor at a certain age; it remains in joint names until the account owners indicate otherwise.

Totten trust or POD (payable on death) account

A Totten trust is a very simple kind of trust that doesn’t require a formal trust document. A Totten trust, also called a POD account, allows an adult to name a beneficiary, including a child, for the account. It’s an easy way to avoid probate costs at death but isn’t a terrific way to teach a child about money since the beneficiary of the account doesn’t have access to the funds until the death of the owner.

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529 plan

A 529 plan, sometimes referred to as an education savings plan allows you to save for your child’s education. The plan takes its name from section 529 of the Internal Revenue Code which is appropriate: The main benefit of the plan is the tax savings. Neither the earnings from the investment nor the distributions or withdrawals from the plan are taxable for federal income tax purposes. Those investments grow tax-free and are never taxed for federal purposes so long as you use withdrawals from the investments for eligible college expenses, which includes most costs associated with college like tuition and room and board as well as fees, books, supplies and equipment. However, if you withdraw money from the plan for a purpose other than eligible college expenses, you will be subject to federal income tax and an additional 10 percent federal tax penalty on earnings.

Tax consequences

For federal income tax purposes, the amount of tax payable for a child’s account depends on three factors: (1) The incidence of ownership; (2) the type of income and (3) the amount of income.

1. Incidence of ownership – The first piece is easy. To the extent that the child owned the account, the child is responsible for reporting the income, if required. To the extent that the child was merely a beneficiary of the account (as is the case with the Totten trust, for example), the child is not responsible for reporting the income; that responsibility falls on the owner.
2. Type of income – The second piece is also easy. Dividends and interest from banking or brokerage accounts are considered unearned income (as compared to wages, tips and salary which are considered earned income). The rules for reporting unearned income are quite straightforward. If there is a mix of earned and unearned income (for example, your child works and has a savings account), the rules can be more complicated: Check IRS Pub 929 for more information.
3. Amount of income – Finally, the amount of income comes into play. For the 2012 tax year, children under the age of 18 or children under the age of 23 who are full-time students treat the first $950 of unearned income as tax-free income; the next $950 is taxed at the child’s rate. Unearned income over those combined amounts, $950 + 950, or $1900, is taxed at the child’s parents’ tax rate. That’s the amount often referred to as the “kiddie tax.”

All of that said, don’t get wrapped up merely in the tax consequences when making your decision about the best way to save. Consider your end goals. Are you trying to teach financial responsibility? Save for a rainy day? Pay for college? The answer to those questions, combined with the tax consequences will help you make the best decision for you and your child.

Updated by Bethany Ramos on 2/4/2016