Teen + Windfall = Disaster?

Worried about the bonanza your child may soon get?

Custodial account remorse: It's the regret you feel about a special type of investment or savings account you set up for your toddler years ago. You thought you were doing the right thing at the time. But now that tot is a reckless teenager, and you're not sure he'll be mature enough to handle this much money when you hand it over to him at age 18 (or 21, depending on the state).

Is there a way to undo your good intentions—or at least put them on hold? The rules in the Uniform Gifts to Minors Act and the Uniform Transfers to Minors Act make it clear that the money belongs to the child and must be transferred when the minor comes of age. But you can take steps to minimize the risk that the funds will be squandered.

No, you can't conveniently forget to mention the account exists. "The first question people ask is: Who's going to know?'" says Douglas Olin, a partner at Cummings & Lockwood, a Greenwich (Conn.) law firm. The answer: your kids. As soon as they start filing their own tax returns, the IRS will ask why they're not reporting their custodial earnings. But here's what you can do:

— Transfer the money to a 529 college-savings plan that accepts custodial funds. (Not all do.) The account still belongs to the child but will now incur a 10% penalty if it is spent on anything other than college. If the student qualifies for financial aid, there's another advantage to this switch: The aid formula treats UGMA and UTMA 529s as parental assets, only 5.6% of which are deemed available to pay for school. But a student must spend 20% of his or her assets on college expenses. So if the money is in a regular custodial account, the student may not get as much assistance.

— Use custodial funds for camp, music lessons, and other expenses for the child—and keep good records. The law specifically allows you to spend the money on things you're legally bound to pay for as a parent. (As long as over 50% of the total support is coming out of your pocket, you can still declare the child a dependent for tax purposes.) Many advisers think it's O.K. to pay for nonessentials, such as camp, but consider it highly unethical to dip into a custodial account for food and clothing.

— Invest the account in an illiquid asset, such as a family limited partnership. This makes it harder for the child to get the money. But you can claim you're doing your fiduciary duty by pooling family assets for better returns.

— The most-often-recommended strategy: none of the above. Many advisers think you should hand over the account when your kid attains legal majority—and lay down the law about how it can be used. "You don't lose your parental authority just because the law says your kid can take the money," says Chicago attorney Kaye Thomas. Tell him you expect him to use it for college or put it into a trust for his own benefit.

Before it's here, it's on the Bloomberg Terminal. LEARN MORE