There are three potential drawbacks to saving in your child’s name: the kiddie tax, federal financial aid rules, and control issues.
First, the kiddie tax. At one time, saving money in a child’s name was recommended because of the tax saving opportunities that resulted when children were taxed at their own rate on all their unearned (passive) income. However, Congress partially closed this loophole many years ago with passage of the “kiddie tax” rules. Under these rules, a child’s unearned investment income over a certain amount ($2,200 in 2021) is taxed at parent income tax rates. The kiddie tax rules significantly reduce the tax savings potential of a child holding assets in his or her name.
The kiddie tax rules apply to: (1) those under age 18, (2) those age 18 whose earned income doesn’t exceed one-half of their support, and (3) those ages 19 to 23 who are full-time students and whose earned income doesn’t exceed one-half of their support. To lessen the impact of the kiddie tax, choose tax-free or tax-deferred investments in which the annual expected income does not exceed the threshold amount of $2,200.
Second, the federal financial aid rules have a more negative impact on child assets than parent assets. Under the current federal aid formula, a child must contribute 20% of his or her assets to college costs each year, whereas parents must contribute 5.6% of their assets each year. So $10,000 in your child’s bank account would equal a $2,000 contribution from your child, but that same $10,000 in your bank account would equal a $560 contribution from you. The more assets a child has, the more he or she will be expected to contribute to college costs, and the less financial aid he or she will be eligible for.
Finally, there is the control issue. Do you want your child to have control over college funds? For example, some parents open a custodial account for their child (UTMA/UGMA) to save for college. However, with a custodial account, when the child reaches the age of majority (18 or 21, depending on the state), he or she gets full control over the money in the account and can use the money for anything, not necessarily college. Some parents aren’t willing to relinquish this control to their child.
For all these reasons, it’s generally recommended that parents save for college in their own names, not their children’s names.