Beginner's Guide to UGMA and UTMA Custodial Accounts

Learn About Using a Traditional Custodial Account to Save for College

Couple planning child's college education. Tetra Images

When making plans to save money for your child's college education, you have many options. One of the more traditional methods is to open a custodial account, which your child can use once they become an adult. This is not an education-only savings account and your kids may use the money you invest however they like.

There are both advantages and disadvantages to UGMA and UTMA custodial accounts and this guide will give you an overview of this type of investment.

When considering your options, be sure to speak with your financial adviser to receive personal advice for your family.

What are UGMA and UTMA Custodial Accounts?

UGMA / UTMA accounts are considered the granddaddy of college savings accounts. Before Section 529 plans and Coverdell ESA’s, parents were successfully using these accounts to accumulate significant amounts of money for their children’s college funds.

The UGMA (Uniform Gift to Minor’s Act) and UTMA (Uniform Transfer to Minor’s Act) are nothing more than custodial accounts. A custodial account is used to hold and protect assets for a minor until they reach the age of majority in their state.

Because the assets are considered the property of the minor, these accounts are often used to take advantage of the “kiddie tax.” The kiddie tax allows a certain amount of a minor’s income to go untaxed and an equal amount to be taxed at the child’s tax rate (as opposed to mom and dad’s rate).

Who is the Ideal Investor for a Custodial Account?

A custodial account is ideal for a parent or grandparent who:

  • Isn’t worried about the assets going to the child if they are not used for college.
  • May want to use the money for pre-college education or expenses.
  • Wants greater investment options than a Section 529 account.
  • Isn’t worried about getting “needs” based financial aid.
  • Wants to lower their taxes on a couple thousand dollars in annual investment income.
  • Wants to lower their eventual estate by using their annual gift tax exclusion.

The Potential Advantages

Aside from the requirement to hand over “control” of any remaining money to a child at 18 or 21, these accounts are extremely flexible. It’s basically up to the custodian (usually the parent) to determine how to invest the money and when to spend it on the child.

Use of this account can help (but not guarantee) that $1,050 of investment income will go untaxed each year, with another $1,050 taxed at the child’s tax bracket.

Important Note: The 2016 "kiddie tax" rate is $1,050 and this is subject to change (often increasing) in subsequent years. For the purpose of this article, it is used as an example and you should check with your tax adviser for the current rates.

The Potential Disadvantages

The same tax benefit that makes custodial accounts attractive can also make them unattractive.

After the first $2,100 in income that has potentially been sheltered from taxes, excess income is taxed at a parent’s marginal tax bracket. This would not occur in a Section 529 plan or a Coverdell ESA.

Additionally, the account requires a custodian to hand over control of the assets to the child at anywhere from age 18 to 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.

Lastly, a custodial account counts heavily against a student’s financial aid application since it is ultimately considered an asset of the child.

What Are Your Investment Options?

Custodial accounts allow typical stock, bond, and mutual fund investments. Due to their custodial and protective nature, they are not permitted ownership of higher risk investments like stock options or buying on margin.

Are There Any Tax Benefits?

One of the important misconceptions about these accounts is that they guarantee that you will not pay income tax on a certain amount of dividends, interest, and gains. The reality is that custodial accounts don’t actually grant this privilege, they simply take advantage of it.

Every child under 19 years old (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. For example, in 2016 the first $1,050 is considered tax-free, and the next $1,050 is taxed at the child’s bracket (10% for Federal income tax). Anything above those amounts is taxed at the parents’ rate, which may be as high as 35%.

This exemption is per child, not per account. Thus, if the child already has a high level of unearned income (e.g., investment income), opening a custodial may not make a difference.

What Expenses are Eligible?

Any expense that is for the benefit of the child may be paid from the custodial account. The funds can be spent at the custodian’s (usually the parent) discretion. Unlike other college savings accounts, expenses are not limited to education and can be used for anything related to the child.

Likewise, once your child becomes a legal adult, they can use the money without limitations. 

What Effect Does It Have on Federal Financial Aid Eligibility?

Custodial accounts are considered an asset of the child they are set up for. Therefore, they are counted heavily against financial aid. Approximately 20% of these assets will be expected to be used toward funding a student’s education in any given year.

Eligibility

Any adult can set up a custodial account for any child under age 18.

Contribution Rules

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.

Contribution Deadline

There is no contribution deadline for custodial accounts.

Withdrawal Rules

A withdrawal can be initiated by the custodian for the benefit of the child as long as the expenses are for legitimate needs. Withdrawals are not limited to college costs and can be used for pre-college educational expenses.

Treatment of Unused Funds

Any unused money must be distributed to the child by the time they reach the age of majority or the maximum age allowed for custodial accounts in their state. For classic UGMA accounts, this is generally age 18. For the newer UTMA accounts, this is usually age 21, but may be as late as age 25.

Unlike Section 529 plans and Coverdell ESA’s, there’s no ability to transfer the account to another child or change beneficiaries.

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