Think twice before creating a UTMA account.
Custodial investment accounts permitted under the Uniform Transfers to Minors Act (UTMA) allow families to gift assets to a child without having to set up a trust. In addition to that convenience, a UTMA can offer a distinct tax advantage to parents. While such perks are nice in the present, the bigger question is what will happen to those assets down the road.
What potential benefits do UTMA accounts offer to families?
Assets in a UTMA account (or UGMA account, the earlier version still used in a few states) are owned by the child, not the parents. As a result, UTMA investment income is generally taxed at the child’s tax rate instead of the parents’ tax rate. That can mean big savings – unless the “kiddie tax” strikes.
In 2013, the first $1,000 earned by a UTMA account is tax-free, providing that child has no other income and is younger than 19 (or younger than 24 and a full-time student whose unearned income does not provide 50% of his/her support). The next $1,000 of investment income from the UTMA is taxed at the child’s tax rate. The kiddie tax kicks in at the $2,000 threshold: account earnings above $2,000 are taxed at the parents’ top marginal tax rate and become part of the parents’ taxable income. (One asterisk: all income will be reported on the child’s tax return if he or she is age 19 and not a student, or age 24 regardless of student status.) Practically speaking, wealthy families can potentially see tax savings via a UTMA account by shifting ownership of some fixed-income securities in a portfolio to a child. As capital gains and dividends aren’t taxed as ordinary income, there is a little less merit in passing such investment income off to a minor.
College keeps growing more expensive, and certain families are just too wealthy to be eligible for financial aid. Some parents create UTMA accounts in response to this dilemma.
What are the potential drawbacks of UTMA accounts?
First of all, the gifts and transfers you make to the minor via the account are irrevocable. The adult custodian only has control over those assets until the minor turns 18 (though UTMA custodianships can last up to age 21 or age 25 in some states).
Once the UTMA custodianship ends, the young adult now in control of the assets can use those assets for any purpose. Anything. What was once seen as a college savings fund may potentially “go to waste” on trivial pursuits.4
Many affluent families assume that their children can’t qualify for college loans and that their kids are out of the running for need-based scholarships and grants. This often proves inaccurate. So if you aren’t yet a multimillionaire, there may not be much reason to have a UTMA account as a college savings fund – it may reduce your student’s eligibility for aid. College financial aid formulas usually demand that students contribute more of their total assets to college costs each academic year (in the neighborhood of 20-25%, sometimes as much as 35%). Parents are typically asked to contribute a much lower percentage of their total assets per year. While there may be a silver lining in proceeding through college with less financial aid (i.e., lower student loan debt for the future), it still amounts to “good debt”.
There are two factors that lead many families away from UTMA accounts toward 529 plans. In a 529 plan, the account holder controls the assets – no control is ceded to the minor. In addition, withdrawals from a 529 plan are tax-free as long as they are used for qualified educational expenses, while withdrawals from a UTMA are taxed above $1,000. A 529 plan allows invested assets to grow with tax deferral as well.
UTMA accounts are hardly the only option.
If you want to make a gift to a child or help a child save for college, in the end, you may determine that a trust, a 529 plan, a Coverdell ESA or a Roth IRA represents a more appropriate choice.