Trust Funds vs. UTMAs
Is It Better to Gift Assets to a Child Through a UTMA or Trust Fund?
When parents, grandparents, uncles, aunts, godparents, or other generous family members or benefactors want to gift wealth to a minor child or minor children, one of the most important decisions they will face is whether to title the assets under a state Uniform Transfers to Minors Act, also known as UTMA, or to place the assets in a trust fund. Both UTMAs and trust funds have unique benefits and drawbacks that make them ideal for certain circumstances.
And you need to know these to determine which is right for your family, or which situation can have a long-term, wide-ranging effect on how the money is protected, who controls the funds, and how the capital can be put to work. My goal in writing this article is to give you a high-level overview of some of the things you might consider when you have decided that you want to help a young person get ahead in life by building their investment portfolio.
What Is a UTMA? How Are UTMAs Structured? What Are the Advantages and Disadvantages of UTMAs?
Let's turn our attention to UTMAs. Simply put, a UTMA is a special type of ownership arrangement that is established under a state's Uniform Transfers to Minors Act and serves as a way for a minor child to own property. When an asset is titled for a child under a UTMA statute, the child becomes the owner of the assets. The gift is irrevocable, meaning it cannot be undone or reversed.
However, until the child reaches the age of majority as specified in the UTMA documents, or, absent a specification, as spelled out in state law, he or she has no right to access or manage the funds. Instead, the property is held in the name of a custodian, for the benefit of the child. While UTMAs can be used for nearly any type of assets, including real estate, intellectual property, precious metals, and ownership in a family limited partnership, we're going to discuss the more common situation, which is facilitating a minor child owning a collection of stocks, bonds, and mutual funds, including index funds.
To that end, the easiest way to establish a UTMA is to open a UTMA custodial account with a broker-dealer. This can be done at either a full service broker or a discount broker.
An illustration might help. Imagine that a Missouri-based father, Thomas Smith, established a UTMA for his daughter, Jane Smith. Further, imagine that he wanted to name himself custodian, and desired to restrict the assets to the latest possible date under the Missouri UTMA statue, which is 21 years old. To accomplish that, Thomas would establish a UTMA custodial account at a brokerage firm, having the account and assets therein titled as "Thomas Smith Custodian for Jane Smith Under the Missouri Uniform Transfers to Minors Act Until the Age of 21" or something effectively similar. This means that until his daughter, Jane Smith, turns 21 years old, Thomas Smith has total control over the UTMA property. It is he who must make the buy and sell decisions for the investments or, as is frequently done in the case of wealthy families with portfolios spanning multiple generations, outsource the job to a white-shoe asset management company.
This arrangement has some substantial benefits. Chief among these is that the assets belong to the child, not the custodian.
This means that, unlike, say, a college 529 Savings Plan or a bank account with the parent listed as a joint account owner, if the parent or custodian file bankruptcy, the assets are not considered part of the bankruptcy estate because they belong to the child. This means the money is generally out of reach from the parent's creditors (or, if the parent is not the custodian, the custodian's creditors) should financial catastrophe strike. On the other hand, it also means that the assets will count against the child when calculating financial aid eligibility for college.
The fact that the UTMA assets belong to the child also introduces some responsibility and complexity. Two things come to mind immediately.
First: As custodian of the UTMA, Thomas is obligated by law to act as a fiduciary for Jane.
This means that he must always put the interest of his daughter above his own as it pertains to the assets in question. This is true even if Thomas was the one who originally made the gift that became UTMA property. This is a point that needs to be highlighted and reiterated. You may recall that you learned in an article called If You're Spending Your Child's UTMA Money, You're Probably Breaking the Law, Jane has certain rights. When she reaches the age at which the UTMA ends, she can petition a court to "compel an accounting" from the fiduciary, her father. This means her father would have to produce documents and receipts demonstrating where every penny of the UTMA money went — how much was received, how much was spent, how much was invested, the dates of those transactions, the performance of the investments, etc. — justifying if any of it was spent on Jane as being in her best interest. Further, at least one court has found that obligations that Thomas would need to cover as an ordinary part of being a parent, such as medical expenses to save Jane's life, must come from Thomas and not from the money he gifted the UTMA as using the latter would amount to embezzlement from his daughter. There have been situations where courts have ordered UTMA custodians to reimburse a child all of the stolen or misappropriated funds plus interest and/or foregone investment income. (The fact you don't hear about these cases terribly often is a testament to the reality that many children aren't keen on trying to send their parent to jail but make no mistake, the potential for civil and criminal consequences is there.)
Second: Due to the fact the assets belong to the child, this means the child has total, and complete, control over how those assets are used once he or she reaches the age at which the UTMA ends. If you put money into a UTMA expecting your son or daughter to go to dental school, there's nothing stopping them from taking the cash, driving to Las Vegas, and spending it all on a weekend debacle of excess and stupidity. This is the price you must pay for the UTMA's ease of administration, low costs, and nearly effortless upkeep throughout its lifetime (presuming, of course, that you are are dealing with fairly simple assets such as common stocks and corporate bonds held by a financial institution that provides regular account statements). There are some ways to potentially mitigate this concern but they are limited. In Pennsylvania, for instance, it is possible to establish a UTMA under some circumstances that won't end until a child reaches the age of 25, which is significantly older than permitted in many other states.
Though it is a terribly misleading and inaccurate description — the wealthy are much more likely to take advantage of UTMAs than the poor, gifting their children cash, property, or securities through a UTMA — UTMAs have been described as the "poor man's trust fund" because they offer some of the advantages of a trust fund without many of the expenses and upkeep requirements. In truth, the children of the wealthy most likely have UTMAs and trust funds.
What Is a Trust Fund? How Are Trust Funds Structured? What Are the Advantages and Disadvantages of Trust Funds?
A trust is is a legal construct that is created when assets are set aside for the benefit of someone who does not control those assets. Specifically, let's look at inter vivos trust funds, which are trusts that are created during the life of the grantor. In these situations, a person, known as the grantor, decides he or she wants to set aside property — cash, real estate, securities, doesn't matter — to benefit another person or group of people, known as the beneficiary or beneficiaries. The grantor wants this property to be managed in a specific way, on a specific set of terms, to comply with their wishes. The grantor's attorneys draw up a legal document known as the trust instrument. This trust instrument spells out a number of provisions and details about the trust, which may include instructions as to how the money is to be invested, the conditions on which funds are to be distributed, and any number of additional items. The trust instrument names a trustee, the person or institution holding title to the assets for the benefit of the beneficiaries and who or which must act in a fiduciary capacity. Sometimes, a trust will also name a so-called "trust protector", often a close family friend, who has the ability to remove the trustee or perform certain other functions to serve as a check on the trustee's power. Usually, but not always, the grantor will be the trustee during his or her lifetime, naming a successor trustee to take over once he or she has died or becomes incapacitated.
If the trust is irrevocable, meaning it cannot be changed or undone, the trust will get register for its own tax identification number, file its own tax return with the Federal and state governments, and pay taxes on certain non-distributed earnings. Trust fund tax rates are compressed so trusts hit higher tax brackets much more quickly than you would with an individual or corporate tax filing. This was a result of Congress desiring, from a public policy perspective, to avoid the creation of trusts that compounded non-impeded for generations, accumulating obscene amounts of capital and creating a modern aristocracy. The thinking goes that by heavily incentivizing the distribution of trust assets, the money is more likely to be spent or donated, benefiting society.
A major advantage of using a trust fund is that it can be personalized to meet your needs. That is, you can tailor almost any solution provided that it does not violate the judiciary's determination that it is so egregious it goes against public policy; e.g., you cannot condition trust fund payouts on the beneficiary remaining a member of a certain religion, marrying someone of the same race, or forbidding them to marry someone of the same gender. For example, you could create a so-called "incentive trust" that makes payouts based upon a beneficiary reaching certain life milestones, such as graduating from a four-year university in a time period of no more than five years with a certain minimum grade point average or matching money they put into retirement accounts on a dollar-for-dollar basis, providing them with spending money to enjoy.
Aside from the additional administrative complexity, trust funds have one big downside, which is cost. Trusts require time, effort, and some liability exposure for the trustee. Trustees, particularly professional trustees, are often compensated. For example, if you have a plain-vanilla trust fund that is fairly straightforward — e.g., you leave behind $500,000 for a niece or nephew with 3 percent payouts to begin on their 21st birthday and the trust distributing all of its assets on their 30th birthday — you could use the services of a place such as Vanguard. In Vanguard's case, you lose much of the ability to buy individual securities, but, depending upon the expense ratio of the underlying mutual funds that are selected, your total costs all-inclusive except for taxes are probably going to run approximately 1.57 percent per annum of principal, which is a fairly attractive deal. (This is not a recommendation for Vanguard. I am simply using them to demonstrate the basic cost structure at one of the major asset management groups that also have the ability to serve as a professional trustee.) If you had a much more complicated trust, those fees could be a lot higher but that is simply life. Deal with it or prepare to roll over in your grave. For example, if you were a successful entrepreneur with a disastrous love life — something that has been known to happen — imagine if you left behind tens of thousands of acres of timberland meant to benefit multiple children across multiple relationships in a way that the legal parent of the child had no access to the money, helping to ensure your off-spring, and your off-spring only, ended up rich. Upon your passing, that nature resource is going to need to be managed and/or potentially sold. If you have a lot of fine-tuned conditions in the trust, it is going to take due diligence and attention to administer it. Get ready to pay substantially more; several percentage points per year may not be unthinkable. It's the cost of providing peace of mind that your life's work won't be squandered. Or, at least, that the chances of your life's work being squandered is greatly reduced and isolated to one or more beneficiaries. I'd gently suggest that this is not an area you'd want to take the low bid. Of course, make sure costs are reasonable and in-line with industry standards but, in the final analysis, service models and capabilities matter as much as investment performance relative to a benchmark when confronting a situation like the one described. If underperforming the S&P 500 by 2 percent per annum is the cost of making sure your child's inheritance doesn't end up in the hands of an ex-spouse, it might be money well spent.
That Leaves the Question — Which Is Better, a UTMA or a Trust Fund?
As you've probably suspected, determining whether a UTMA or a trust fund is better in any given situation depends upon a number of factors. The three most important are:
- The amount of money you are considering setting aside for the minor child. Generally, but not always, the smaller the amount, the more likely you are going to want to go with a UTMA though, again, it seems as if it is wealthy families that take advantage of UTMAs most, pairing them with trust funds for specific purposes.
- The restrictions you want to place on the money. If you absolutely insist that the funds be used for a specific purpose — again, within the public policy limits permitted by the judiciary as the money in trust is no longer yours — a UTMA is not going to be ideal.
- The need for asset protection. Good attorneys can often use trust funds in intelligent ways to protect beneficiaries beyond what might be possible with a UTMA. This may not always be ideal from the point of view of the civilization — e.g., a high school student who gets drunk, drives, and kills someone could probably have UTMA assets reached in a liability lawsuit where it could be much harder to break into a properly-structured trust, particularly if there are contingent beneficiaries or remaindermen. (When discussing trust funds, remaindermen are the people who inherit the trust in the event the beneficiary dies. For example, if you created a trust that provided income for life for your niece, and then said, upon her death, all of the principal was to go to her children, or, perhaps, charity, the children or charity would be the remaindermen.)
In any event, this is an area where you absolutely need to have a serious discussion with your qualified advisors, including an estate attorney, a CPA that has familiarity with trust taxation, and, depending upon the assets, perhaps a registered investment advisor, particularly if you are dealing with meaningful amounts of money.