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Custodial Account Or Trust? Which Is Best For Children?

At least once a year we get a frantic call from a parent with a slightly out of control minor or adult child. The question from the parent is, “Can the child get at the money in the custodial account”? The answer is usually a simple yes or no, but it underscores a more important question. How should parents make cash gifts to children? The answer is pretty easy. Use an irrevocable trust and not a 2503(c) or minors trust.

Notice I said gifts to children and not gifts to minors. Under Colorado law, the money in a Uniform Gift To Minors Account, a/k/a custodial account a/k/a UGMA are not available to the child until the child is 21 years of age. The funds can be used for the child prior to age 21. However, the child has no ability to just abscond with the money.

Custodial accounts can have significant assets by the time a child becomes 21 years old. At the time the money was socked away, nobody thought about the rebellious years, a bad car accident, medical bills, a nasty divorce, a manipulative boyfriend or a questionable marriage at a young age. All of these events provide the opportunity for this hard-earned money to quickly disappear.

A 2503(c) trust or minor’s trust is not a solution because at some young age, usually age 21, the child will have unfettered access to the money just like they would with a Colorado custodial account. To make a long story short, the primary advantage of the 2503(c) trust is the ability to make gifts to the trust without using up the donor’s lifetime gift tax exclusion. Most people know that they can give $13,000.00 per year to a child without incurring any gift tax or using any gift tax exemption. What they don’t know is that a gift to an irrevocable trust does not qualify for the $13,000.00 annual exclusion because it is not a present interest gift. However, the 2503(c) trust is an exception to that rule, and the gift to the 2503(c) trust qualifies for the $13,000.00 exclusion. What is the trade off? The child has access at age 21.

The solution is an irrevocable trust. However, there are some rules to follow, a tax return to file and some money to be spent to set it up. For a gift to the trust to qualify for the $13,000.00 annual exclusion, the irrevocable trust must be structured very much like a life insurance trust and allow a 30 day window for the gift to be withdrawn. If the trust investments throw off capital gains or income, then a trust tax return must be filed. If the trustee is located in Colorado, the trust must be registered. These requirements plus the lawyer fee tend to discourage the use of irrevocable trusts for children.

Keep in mind that the lawyer fee can be kept to a minimum by using a standardized trust. Only one trust needs to be created for multiple children or beneficiaries. Tax issues can be minimized through the use of life insurance products, investments that are growth oriented and by distributing trust income to a parent or guardian.

The benefits of the irrevocable trust are enormous. There is no set time that the child is entitled to the trust assets. A child’s creditors or spouse cannot take the trust assets. The parent can control the use of the trust assets for decades without having those assets included in their taxable estate or taken by their creditors. The child cannot demand a distribution and can even be cut off for many years.

The benefits of an irrevocable trust greatly outweigh the initial cost of creating the trust. Very few children make it through life without a couple rough spots. When those rough times come, the irrevocable trust is a very valuable tool to preserve wealth for the child and the family.