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One of the best things you can do to help a child’s future is to give them financial backing. For example, you can deposit money in their savings account that they can use later in life to pay for school, a house, or to start a business.
However, there are tax implications involved with giving money to children that you need to know about.
The Uniform Gifts to Minors Act (UGMA) and the Uniform Transfers to Minors Act (UTMA) are legal vehicles through which you can pass money to minors. Keep reading to learn more about how these programs work and what makes them different.
What Is UGMA?
The Uniform Gifts to Minors Act (UGMA) was launched in 1956 and updated in 1966. In short, the UGMA is a custodial account that enables adults to transfer or gift assets to beneficiaries who are under the age of 18. UGMA is a common way to help pay for a child’s college costs.
Typically, the types of assets that you can donate with a UGMA are stocks and bonds, and the account reaches maturity when the beneficiary reaches the age of 18.
How a UGMA account works
To invest in a UGMA, the account holder will either declare themselves, someone else, or a financial provider the account’s custodian. In short, this gives the individual the authority to control how the fund operates—including which investments are made. UGMAs often contain a mix of stocks, bonds, and funds.
You can form a UGMA through just about any financial institution (e.g., Vanguard, Schwab, and Fidelity). Once the account is ready, people other than the custodian can contribute to the account, like family members or friends.
The pros of UGMA
Avoids gift tax
Money deposited into a UGMA is exempted from gift taxes, so long as the contributions don’t exceed $15,000 annually.
Minors often use UGMAs when saving for college, and donors can make withdrawals as needed to cover expenses for the individual without facing penalties.
When the beneficiary reaches adulthood (either 18 or 21, depending on the state of residence), the custodian must transfer assets to the beneficiary. This process is pretty seamless, meaning there is no complicated or lengthy transfer process to switch control of the UGMA.
The cons of UGMA
Contributions are taxable
One of the downsides to using a UGMA is that they do not shelter from taxes. In fact, the earnings are taxed on an annual basis. The good news is that UGMAs are taxed at a child’s tax rate – or kiddie tax rate – which is most likely lower than the donor’s.
In addition, a federal gift tax may apply for exceeding the $15,000 contribution threshold for single donors or $30,000 for married couples.
Withdrawals are binding
Once an account withdrawal occurs, the funds must go toward the child’s direct benefit. In other words, you can’t put $20,000 into a UGMA and then use the money to repair your roof or buy a new car.
On the one hand, this protects the child’s assets. On the other, it can be restricting for families, especially if emergencies arise.
Beneficiaries are fixed
A beneficiary cannot be changed once an account is set up. Again, this protects the child but limits flexibility. The main issue is that you can’t roll one child’s UGMA funds over to another child in the family. Once the money goes into the account, it has to go to the beneficiary on the account.
What is UTMA?
The Uniform Transfers to Minors Act (UTMA) is another type of custodial account that enables minors to receive gifts from donors. It is an extension of the UGMA and was implemented in 1986.
The UTMA is a little different than the UGMA because it allows for a wider range of assets to be donated. For example, you can donate real estate to a minor, a car, life insurance, and even a patent. Also, in some states, the age of maturity is 25 (whereas it’s 18 for a UGMA).
How a UTMA account works
Much like the UGMA, the UTMA enables a custodian to manage a child’s account until they can legally do so. The custodian can make contributions, as well as withdrawals, as they are needed.
The pros of UTMA
One of the key differences to a UTMA is that you can invest in a wider selection of assets. While UGMAs are typically limited to investing in publicly traded securities, UTMAs can contain almost any type of asset. For example, you can invest in real estate through a UTMA.
Gift tax exemption
Like UGMAs, UTMAs offer a gift tax exemption for annual donations up to $15,000 for individual donors and $30,000 for married couples.
The cons of UTMA
UTMAs are taxable
There are no tax penalties for withdrawing UTMA funds. However, the account is subject to capital gains, dividends, and interest tax. It is also subject to a lower tax rate.
UTMAs also have binding withdrawals, mandating that the funds go directly towards the child.
Quick comparison: UGMA vs. UTMA
Now that you have a basic understanding of how UGMAs and UTMAs work, here’s a quick breakdown of how they compare to one another.
Both UGMAs and UTMAs are easy to set up through a bank or brokerage firm. The most important benefit is that neither approach requires having to set up a trust, which saves a substantial amount of time. Simply put, these are some of the quickest and safest ways to start funneling large sums of money to a child.
Impact on federal student aid
One concern that parents often have is how UGMA and UTMA impact financial aid and FAFSA – and whether they’re better than 529 college savings plans, or Coverdell education savings accounts (ESAs).
UGMA, UTMA, 529 savings plans, and ESAs all need to be reported as assets when applying for federal financial aid. So they cannot be used for sheltering education funds and may impact eligibility for assistance.
529 plans offer greater tax savings over UGMA and UTMA accounts, as they enable investments to grow on a tax-free basis. What’s more, taxes don’t have to be paid on qualified education expenses.
The child is the legal owner of UGMA and UTMA accounts and gets up to $250,000 coverage from the Federal Deposit Insurance Corporation (FDIC) should the bank or brokerage account fail.
Of course, the FDIC can’t protect against investments that go south. The stock market is naturally volatile, and losses can occur when investing in stocks or mutual funds.
All funds must be distributed to the beneficiary when the child reaches the maximum age, as determined by their state of residence.
As such, UGMAs and UTMAs can’t be used for multiple beneficiaries. In other words, you can’t set up an account for one child and then roll unused funds into another beneficiary for educational expenses. With both accounts, the money has to go to the original beneficiary of the fund.
UGMA and UTMA accounts both offer a great deal of flexibility. For example, both accounts enable custodians to withdraw money at any time as long as the money goes towards the benefit of the child.
Oftentimes, parents fund these accounts early on, let the money grow, and then use the funds to pay for school supplies, sports, music lessons, SAT classes, and things of that nature. If you build up the accounts enough, a child may be able to avoid taking out student loans altogether.
Neither account comes with contribution limits. You can put any amount into a UGMA or UTMA. However, there are tax implications for exceeding the $15,000 or $30,000 thresholds.
Frequently Asked Questions
What is the age of majority?
The age of majority is the point when a minor switches to a legal adult. States have varying laws outlining the official age of adulthood. In most states, 18 is the age of majority, and in others, it’s 21 years of age.
It’s important to understand the age of majority when setting up an account so that you have a clear understanding of when the responsibility shifts to the individual. Also, some states allow extensions on the age of majority.
Why are UGMA and UTMA custodial accounts?
These types of accounts are custodial accounts because a legal custodian or manager maintains them. The custodian is responsible for managing the money in the account and distributing it to the beneficiary when it is required.
That said, the beneficiary is still the owner of the account. A custodian assumes no ownership rights when working with a beneficiary.
Can you use UGMA and UTMA accounts for higher education expenses?
These accounts are often used to meet investment objectives for children so they have money to fund their college education.
That said, these accounts do not have to go towards educational purposes. For example, if the child decides not to go to college, their UTMA account money could be used to fund an apprenticeship or internship, or buy a house or apartment.
Are UGMA and UTMA accounts tax-advantaged?
These accounts are both subject to annual federal income tax by the IRS. Unlike a 529 plan, you cannot use them to defer income taxes. The best tax advantage that they offer is that they are taxed at a lower rate, which is a benefit which goes directly to the beneficiary.
The Bottom Line
Both UGMA and UTMA accounts are good places to tuck money away for minors.
All too often, kids get thrust into college or the working world with no money to their name. As a result, they can quickly spiral into debt, and have trouble making ends meet. This is why many recent college grads return home after graduating.
Just a little bit of financial planning when a child is young can go a long way. By putting money away when your kids are small and investing it, they will be in an advantageous position when it comes time to make it on their own.
You really can’t go wrong with a UGMA or UTMA. It really comes down to which assets you plan to donate, and at which age you prefer the account to mature.
Whichever direction you choose, it’s probably a good idea to have your accountant or financial advisor review your strategy to ensure you are following all of the right steps.
Here’s to reaching financial freedom and helping our loved ones do the same.