As a parent or guardian, planning for your child’s needs is top of mind. Lots of times, this leads to a conversation about saving for college, but focusing solely on education might not be the best fit for every child. Enter the UTMA or UGMA account, also known as the custodial account.
What is a UTMA or UGMA account?
UTMA and UGMA accounts are taxable investment accounts set up to benefit a minor, but controlled by an adult custodian (parent, guardian, relative, etc.) until the minor reaches their age of majority — when a minor is legally considered an adult, which differs by state. At that point, the account assets transfer into the name of the minor, and they take over from there.
For these custodial accounts, their names say a lot. The acronyms hail from the state laws that put these accounts in place — the Uniform Transfer to Minors Act and Uniform Gifts to Minors Act. The Uniform Gifts to Minors Act came first and is valid in all 50 U.S. states. It allows gifts of cash or securities to be given to minors without tax implications, up to gift tax limits. The Uniform Transfer to Minors Act expanded gifts to include property and other transfers for those states that have adopted it (all U.S. states except South Carolina and Vermont).
Although the custodian in these accounts invests and manages the account, only the minor can use or benefit from it — the account and assets within are irrevocable and considered property of the minor. This means that the minor is also responsible for paying taxes on any investment income earned. Usually, the first $1,100 of unearned income is free from tax. The next $1,100 is taxed at the minor’s tax rate. Earnings above $2,200 are taxed at the parents’ tax rate.
Why use a UTMA or UGMA account?
Not everyone ends up attending college. The UTMA or UGMA account helps a minor save and invest while providing flexibility.
Perhaps your child is better suited for an apprenticeship or is being groomed to take over the family business. Or, you may want your child to take out a loan and be responsible for covering the cost of their own educational expenses. Parents of children with disabilities might want to invest to make sure their children are taken care of financially. ABLE accounts are tax-free savings vehicles that can be an effective option to consider.
UTMA or UGMA vs. 529 or Coverdell ESA
If saving for education is a key goal, comparing UTMA or UGMA accounts with 529s or Coverdell education savings accounts (both options geared toward saving for education) can help you narrow down the best option for your family situation.
According to IRS rules, both 529s and Coverdell ESAs are meant to be used for qualified educational expenses (tuition, books, etc.) and if not, withdrawals are subject to a 10% federal penalty. There are no use requirements when it comes to withdrawals from UTMA and UGMA accounts.
Additionally, 529s and Coverdell ESAs are subject to contribution limits. There are no annual contribution limits for 529s, but there are aggregate contribution limits to be aware of. Coverdells have annual contribution limits and eligibility restrictions based on income. UTMA and UGMA accounts do not have any limitations on contributions.
However, 529s and Coverdell ESAs provide tax-advantaged growth whereas UTMA and UGMA contributions are taxable accounts. With 529s, the beneficiary can be changed to another if the current beneficiary doesn’t need the money, which is not possible with UTMA and UGMA accounts.
Bypass setting up a trust
Another perk of UTMA and UGMA accounts is sidestepping the need to set up a trust when giving assets to and managing assets for your child or another minor. The custodian handles and invests the account assets in the best interest of the beneficiary without needing to hire an estate-planning attorney or draw up legal documents.
Caveats about UTMA and UGMA accounts
Once your child turns the age of majority, the account assets are theirs. Depending upon the amount of assets and your child, this could be a significant financial responsibility to take on. Even if your intention was for the money to go toward education, nothing prevents your child from purchasing their first motorcycle and riding off into the sunset instead. In contrast, a trust can provide more control and rein in undesirable spending.
Since the account assets are considered theirs, UTMA and UGMA accounts are reported as such when it comes to applying for college financial aid. Your child’s eligibility for aid will be reduced by 20% of their UTMA or UGMA account asset value. In comparison, 529s and Coverdells reduce aid by only up to 5.64% of the asset value because these plans are considered property of the parent.
But if education isn’t your key concern, UTMA and UGMA accounts can provide you and your child with less restrictions and more options when saving and investing for their future.
Benefits of UTMA or UGMA accounts
Drawbacks of UTMA or UGMA accounts
How to get started with a UTMA or UGMA account
If you’re ready to get started with a UTMA or UGMA account, we’ve outlined the process of opening a custodial account and answered some frequently asked questions.