UTMAs vs. Trust Funds

Is It Better to Gift Assets to a Child Through a UTMA or Trust Fund?

A grandfather and his grandson enjoy a day out in nature
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One of the biggest choices parents or other family members can face when they want to gift a large sum of money to a minor child is how to do it. The method you choose when giving assets to a minor child can have a great impact on how those assets are taxed.

Two of the main ways you can gift assets to a minor child are the Uniform Transfers to Minors Act (UTMA) or to placing them in a trust fund. While both options have good aspects that can make them ideal for certain cases, there are also some drawbacks to be aware of.

UTMA Basics 

UTMAs are custodial accounts that are subject to rules for how the account can be opened and used. A custodial account is one in which money or assets are placed in the name of a child. A UTMA serves as a way for a minor child to own property.

The child is the owner of the assets when they're given under a UTMA. The gift is irrevocable. This means it can't be undone and the money can't be taken back by the giver for any reason. The child has no right to access or manage the funds until they reach the age of majority as spelled out in the UTMA documents. The assets are held in the name of a custodian for the child until they reach that age.

Unless the UTMA documents say otherwise, the age a child must be to receive the assets from the account is usually 18 or 21.

UTMAs can be used for nearly any type of asset. This includes real estate, intellectual property, precious metals, and ownership in family limited partnerships. The most common assets found in UTMAs include stocks, bonds, mutual funds, and index funds.

UTMAs offer some of the best features of a trust fund without many of the costs and rules you'll find in a trust. UTMAs are popular because of the low costs and easy upkeep they offer.

Setting up a UTMA

The most simple way to set up a UTMA is to open a custodial account at a brokerage. This is a place where people set up their investment accounts. You may choose to use a full-service broker or a discount broker.

A UTMA Example

Here's how a UTMA works:

Thomas Smith, who lives in Missouri, establishes a UTMA for his daughter, Jane Smith. He wants to name himself as custodian and restrict the assets to the latest possible date under the Missouri UTMA statute, which is 21 years old.

Thomas sets up a UTMA custodial account, naming the account and the assets as "Thomas Smith Custodian for Jane Smith Under the Missouri Uniform Transfers to Minors Act Until the Age of 21." He has total control over the account until Jane Smith turns 21 years old. He makes the buy and sell choices for the investments in the account. He can also opt to have an asset management company watch over the account and make decisions on it.

Jane has total and complete control over how those assets are used once she reaches the age at which the UTMA ends. Nothing stops her from taking the cash to Las Vegas and spending it all in a weekend, even if Thomas put money into the UTMA with the hope that she would use it to go to dental school.

UTMA Advantages

Remember, these UTMA assets belong to the child, not to the custodian. Unlike a college 529 savings plan or a bank account with the parent listed as a joint account owner, the assets aren't considered part of an estate if the parent or custodian files for bankruptcy.

Money in a UTMA is out of the reach of the custodian's creditors, should financial trouble befall him or her.

UTMA Drawbacks

The value of the assets in a UTMA will count against the child, who is the owner of the account, when federal financial aid eligibility for college is determined. Financial aid is based on the assets of the student. The fewer assets a student has, the more financial aid they will receive to pay for school. Money in a UTMA could reduce the amount of a student's aid reward. This rule wouldn't affect an adult custodian who wanted to go back to school, according to FAFSA.

Custodial Duties and Responsibilities

The custodian has the duty by law to act as a fiduciary for the child. This means that they must always put the interest of the minorF above their own with regard to the UTMA's assets. This holds true even if they were the one who gave the assets that became part of the UTMA.

The minor has certain rights. When they reach the age at which the UTMA ends, they can petition a court to "compel an accounting" from the fiduciary to ensure that the handling of the assets was done right.

From the example, if Jane asked for an accounting from her father, he would have to produce documents and receipts showing where every penny of the UTMA money went. He needs to divulge how much was given, how much was spent, and how much was invested. He must produce the dates of those transactions and discuss how well the investments did.

At least one court has found that costs Thomas would have to cover as part of being a parent, such as medical costs, must come from Thomas and not from the money he gifted the UTMA. Using UTMA money against the rules is considered embezzlement.

Courts have ordered UTMA custodians to pay back a child all of the stolen or misused funds plus interest and/or missed investment income.

Trust Fund Basics 

A trust is a legal agreement to hold assets to be set aside for the benefit of a person who doesn't control those assets. "Inter vivos," or living trusts, are set up during the life of the "grantor." The grantor is the person who creates and funds the trust.

The grantor sets aside assets, which can include cash, real estate, securities, or other items of value, to benefit another person or group of people who are called beneficiaries. The grantor can direct that the assets are to be managed in a certain way with a specific set of terms.

Setting up a Trust Fund

Trust funds are made when the grantor's lawyer draws up a legal document known as the trust instrument. This item spells out the rules of the trust. Rules might include guidance on how the money is to be invested and how and when the funds can be given to the beneficiary.

The trust instrument also names a trustee. This is a person or institution who will manage the assets on behalf of the beneficiary. The trustee must also act in a fiduciary role. 

A trust may also name a "trust protector." This is often a close family friend who has the ability to remove the trustee or perform certain other tasks to serve as a check on the trustee's power.

Revocable vs. Irrevocable Trusts

Most but not all of the time, the grantor will act as trustee during their lifetime. They will name a successor trustee to take over when they die or can no longer perform trustee duties. A trust that allows this kind of setup is called a revocable trust. It's good because if the grantor dies, the next person can take control of the trust. The trust will not be part of any probate proceedings.

The grantor can't change or undo the trust if it's irrevocable. The trust is given a tax identification number. Federal and state tax returns are filed on behalf of the trust. The trust pays taxes on certain earnings.

An irrevocable trust is an entity separate and apart from the grantor. It avoids probate, and it avoids estate taxes on the value of its assets as well because the trust owns them, not the grantor.

Trust fund tax rates are compressed, so trusts hit higher tax brackets much more quickly than with individual or corporate tax filings.

Advantages of Trust Funds

A major plus of using a trust fund is that it's flexible enough to meet most people's needs. You can tailor its terms to almost any situation as long as it doesn't go against the law.

If you start a trust fund for someone, you can't make a rule that the beneficiary can only get payouts if they remain a member of a certain religion, marry someone of the same race, or not marry someone of the same sex.

You can create an "incentive trust" that makes payouts based upon the beneficiary reaching certain life milestones. For instance, you could say that he or she must graduate from a four-year college in no more than five years with a certain grade point average. Or you might match money they put into retirement accounts on a dollar-for-dollar basis, providing them with spending money to enjoy.

Drawbacks of Trust Funds

Trust funds have one big downside: their cost. They require time and effort, and there's some liability exposure for the trustee. Professional trustees are often paid for their efforts.

You could use the services of an asset management firm if you have a fairly simple trust fund. For example, you leave behind $500,000 for a niece or nephew with 3% payouts to begin on their 21st birthday. You'd lose much of the ability to buy individual securities, but your total costs except for taxes might run about 1.5% per year of principal. Those fees could be a lot higher if you had a much more complicated trust.

UTMA vs. Trust Fund—Which Is Best?

Determining whether a UTMA or a trust fund is better in any given situation depends upon a number of factors:

  • The amount of money you want to set aside for the child. Most of the time, but not always, you'll use a UTMA if the amount of the gift is smaller.
  • The restrictions you want to place on the money. A UTMA is not going to be ideal if you want to insist that the funds must be used for a specific purpose.
  • The need for asset protection. A good lawyer can often use trust funds in smart ways to protect beneficiaries beyond what might be possible with a UTMA.

This is an area you should discuss with qualified advisors, such as an estate lawyer, a CPA who knows about trust taxes, and—depending upon the assets—perhaps an investment advisor. This is even more true if you're dealing with large amounts of money.

Key Takeaways

  • UTMAs are lower cost and better for simple arrangements, while trust funds are better for more complex plans but cost more to set up and manage.
  • If you want the money to be used for a specific purpose, a trust fund is a better way to go.
  • Trust funds remain out of probate court if a backup trustee is named.
  • UTMAs are safe from the creditors and bankruptcy proceedings of the grantor.