Before you rush out to invest your baby's shower gifts in savings bonds or commodities, consider an investment's tax consequences. While your child is learning the ABCs, learn a few new letters yourself: UGMA and UTMA. The Uniform Gift to Minors Act and the Uniform Transfer to Minors Act are state laws that define special types of accounts designed to make it easy to put securities in minors' names. Under these provisions, the minor is the owner of the securities, but an adult acts as custodian of the account, responsible for prudently investing assets until the child reaches the age of majority. (The age for termination of the custodianship varies among states, so consult your tax advisor.) Potential tax savings in these types of accounts can be substantial: The first $650 in annual investment income in a minor's account is exempt from tax, regardless of his or her age. The next $650 is taxed at the minor's rate of 15 percent. Amounts earned over $1,300 are taxed at the parents' highest marginal rate. Once the child reaches age 14, all annual investment income greater than $650 is taxed at the minor's rate.
UTMA and UGMA accounts are a great idea for some investors, but large amounts of assets built up in these accounts could interfere with your child's ability to qualify for financial aid. Rules for qualifying for aid are subject to change, but currently, schools expect students to use 35 percent of their own assets and 5 percent of their parents' assets to pay tuition before they can apply for need-based financial aid.
If you're an older parent whose children will attend college after you reach age 591|2, consider saving for their educations by fully funding your retirement accounts, through tax-deferred annuities or through real estate investments. Savings here grow without tax until withdrawal and won't be counted as part of your assets when schools look at your financial aid application. And, unlike UTMA and UGMA accounts, these assets are your property, not your child's. You still have control over them (and maybe over your kid!) when your child reaches the age of majority.