Beginner's Guide to UGMA and UTMA Custodial Accounts
Is a Custodial Account for Your Kid's College Fund Ideal?
Parents and students who are currently completing the FAFSA and learning about financial aid may be kicking themselves for not having a better plan in place to pay for college. When it comes to college costs, a little planning can go a long way. There are several useful ways to save money for your child's college education, each of which has its pros and cons.
One of the more traditional methods is to open a custodial account, which children can access once they become adults, but this doesn’t place any educational criteria on how money is spent. A custodial account is not an education-only savings account, and your kids may use the money you invest however they like. Another option is to utilize a UGMA or UTMA account.
UGMA and UTMA Custodial Accounts
UGMA and UTMA accounts are considered the granddaddy of college savings accounts. The UGMA (Uniform Gift to Minors Act) and UTMA (Uniform Transfer to Minors Act) are nothing more than custodial accounts, which are used to hold and protect assets for minors until they reach the age of majority in their state. These accounts typically allow stock, bond, and mutual fund investments, but not higher-risk investments like stock options or buying on margin. Because the assets are considered the property of the minor, a certain amount of the investment income will go untaxed while an equal amount is taxed at the child’s tax rate, instead of the parents’ rate.
The same tax benefit that makes custodial accounts attractive can also make them unattractive. After the first amount of money in income is sheltered from higher taxes, excess income is taxed at the parents’ marginal tax bracket. This effect would not occur in a Section 529 plan or a Coverdell ESA. The account format also requires a custodian to hand over control of the assets to the child anywhere from age 18–21, depending on the state. While parents who have a good relationship with their child might be able to coerce those assets into actually being spent on college, a strained relationship may present a problem.
Every child younger than 19 (or 24 for full-time students) who files as part of their parents’ tax return is allowed a certain amount of unearned income at a reduced tax rate. In 2020, for example, the first $1,100 is considered tax-free, and the next $1,100 is taxed at the child’s bracket, which is 10% for federal income tax. Anything above those amounts is taxed at the parents’ rate, which may be as high as 37%. This exemption is per child, not per account.
A custodian can initiate a withdrawal for the benefit of the child, as long as the expenses are for legitimate needs. Any expense that is for the benefit of the child, such as pre-college educational expenses, may be paid from the custodial account at the custodian’s discretion. Unlike other college savings accounts, however, these expenses are not limited to education and can be used for anything related to the child. Likewise, upon becoming a legal adult, the child can use the money without limitations.
Impact on Federal Financial Aid Eligibility
Custodial accounts are considered an asset of the child and are counted against financial aid. Approximately 20% of these assets will be expected to be used toward funding a student’s education in any given year.
There are no contribution limits. However, someone setting aside money in one of these accounts needs to be aware of how larger gifts affect their annual gift tax and lifetime estate tax exclusions. Consulting a financial adviser is helpful.
Any unused money must be distributed by the time the child reaches the age of majority or the maximum age allowed for custodial accounts in their state. For classic UGMA accounts, this generally occurs at the age of 18. For the newer UTMA accounts, this age is usually 21, but may be as late as 25. Unlike Section 529 plans and Coverdell ESA’s, there’s no ability to transfer the account to another child or change beneficiaries.