By Jamie Johnson, WCI Contributor
Traditionally, parents who wanted to save money for their children’s future would open a college savings plan. But undergraduate enrollment has declined over the last two years as some teens decide that college isn’t the right path for them. If you’re preparing for your child’s financial future and aren't sure they'll actually go to college, opening an UGMA or UTMA account could be a good option. These accounts are also excellent options for money you wish to give for purposes other than college such as the Dahles' infamous “20s Funds.”
These are taxable investment accounts you set up for your minor child and are managed by an adult guardian until they reach adulthood. Here's what you need to know about UGMA and UTMA accounts.
UGMA vs. UTMA
Both UGMA and UTMA are custodial accounts, which allow adults to manage money for a minor. Many parents set up an UGMA or an UTMA account in place of a 529 College Savings Plan, which is money that can be saved by an adult for a minor that must be used for education-related expenses. But an UGMA or UTMA could be a great option for parents who want to set aside money for their children but aren’t sure of their college aspirations.
These accounts are similar, but there are several distinct differences between the two. The main difference is summed up by the names of these two accounts: Uniform Gifts to Minors Act (UGMA) and Uniform Transfer to Minors Act (UTMA).
An UGMA account is a gift, while an UTMA account is a transfer. But what are the guidelines parents need to know about before choosing one of these custodial accounts?
What Is an UGMA Account?
An UGMA account allows the custodian to use the funds to buy stocks, bonds, and other securities on behalf of a minor. You can open an UGMA through a bank or brokerage account, and friends and family members are allowed to make contributions.
There are no maximum contributions or income limits. But there are no refunds available either—if you or anyone else decide to contribute to a UGMA account, these deposits are permanent.
What Is an UTMA Account?
The UTMA account is an extension of the Uniform Gifts to Minors Act, which was developed in 1956 and revised in 1966. The UTMA account allows minors to receive gifts and avoid tax penalties until they reach adulthood.
An UTMA account lets you transfer assets to your minor child without setting up a trust. In addition to holding typical securities like stocks and bonds, UTMA accounts can hold life insurance policies, real estate, and alternative investments.
What Can UGMA and UTMA Accounts Be Used For?
As the custodian on the account, you can use the funds however you like as long as it’s in the minor child’s best interest. You have a fiduciary duty to manage the account on behalf of your child until they reach adulthood.
You can choose to spend the funds on your child’s education, just like you would with a traditional college savings plan. But you can also use the money on anything you believe will benefit your child, including summer camps, tutoring, and more.
Once they are adults the money can be used for anything, but common uses would include college, grad school, house down payments, cars, missions, weddings, honeymoons, and vacations. The important thing to remember is that it becomes the minor's money at some point, so if they want to use it for something you do not approve of, there is nothing you can do about it.
Impact on Student Aid Eligibility
If you think your child will want to attend college eventually, you may want to rethink setting up an UGMA or UTMA account. That’s because the funds could affect their ability to qualify for financial aid.
When your child fills out the FAFSA (Free Application for Federal Student Aid), the money in their UGMA or UTMA account will count against them. That’s because your assets and your child’s assets will be listed on the form for student aid.
And while your assets will be counted at a rate of 5.64%, your child’s assets will be counted at a rate of 20%. So if your child has an UGMA or UTMA, they’ll likely receive less money in financial aid.
Who Should Utilize an UGMA or UTMA Account?
An UGMA or UTMA account is an excellent way to save for your child’s future if you aren’t sure they’ll want to attend college. It's also a much easier way to set aside assets for your child than setting up a trust.
However, your child will gain access to the funds once they reach adulthood. And if you want your child to use the money for educational expenses, a 529 plan may be a better choice.
How to Open an UGMA or UTMA Account
You can open an UGMA or UTMA account through a bank or brokerage firm. To get started, you’ll need to choose a broker. Look for one that doesn’t charge any fees and doesn’t have minimum deposit requirements.
From there, you can easily open a custodial account for your child. You’ll have to provide the following information:
- Name and contact information
- Social Security Number
- Your child’s Social Security Number
- Your birthday
- Your child’s birthday
- Employment information
From there, you’ll have complete access to the account. You can save, spend, or invest the money as you see fit, as long as it’s in your child’s best interest.
Do I Have to Pay Taxes on an UGMA or UTMA Account?
UGMA and UTMA accounts are subject to what the IRS calls a “kiddie tax.” Any money that is in the account is considered unearned income. If the child’s unearned income is less than $2,200 a year, you'll pay taxes for the child's tax bracket for trusts and estates. For most people, that means their taxes will be next to nothing.
But if the unearned income exceeds $2,200, you’ll have to pay taxes on the unearned income. However, if the amount is less than $11,000 per year, you’ll have the option to include it on your annual tax returns.
The Bottom Line
If you’re considering opening a custodial account for your child, it’s important to consider your goals first. For instance, if your primary objective is to save money for your child’s college education, opening a 529 account is probably a better plan.
But an UGMA or UTMA account can make sense in certain situations. These accounts are easier than setting up a trust and are a good way to manage gifted funds or an inheritance until your child is an adult.
If you’re not sure what the right choice is for your situation, it can help to consult with an attorney or tax specialist first. They can help you evaluate your options and determine the right path for you and your child.
The White Coat Investor is filled with posts like this, whether it’s increasing your financial literacy, showing you the best strategies on your path to financial success, or discussing the topic of mental wellness. To discover just how much The White Coat Investor can help you in your financial journey, start here to read some of our most popular posts and to see everything else WCI has to offer. And make sure to sign up for our newsletters to keep up with our newest content.
Thank you for the article. Very helpful.
Just a point of clarification, is the tax applied to interest/realized gains on the money or do I owe taxes when it is funded as well? Example, if I put in $7500 in the account, should I file a gift tax for this amount or only on the realized gains on this investment? Thanks!
After tax money goes into UGMA/UTMAs, so yes, you’d owe income tax when you make and contribute the money. Then again on any earnings. Think of it as a taxable investing account for your kids, not another investing account for you.
You don’t file a gift tax return unless you give more than $17K per year. Gains don’t belong to you because after the contribution, it’s your kid’s money.