Summary:
- If you read our Building Generational Wealth blog, you may recall that there are accounts called UGMAs or UTMAs, which allow for the transfer of assets from an adult to an underage beneficiary. UGMA stands for The Uniform Gifts to Minors Act, developed in 1956 and extended in 1986 to include the Unform Transfers to Minors Act.
- UGMA/UTMA accounts are setup by an adult who designates a minor as the beneficiary. Anybody can make contributions to the account over time, and the beneficiary takes control of the assets in the account when they become an adult.
- There are no contribution limits, and no withdrawal penalties, but the accounts are not tax advantaged.
- UGMA/UTMA accounts offer flexibility compared to retirement accounts and 529 plans.
The Basics
UGMA/UTMAs are accounts that are managed by and contributed to until the account beneficiary reaches the age of majority (“adulthood”), at which point the beneficiary takes control of the account. The age of majority varies by state, in Washington state the age of majority is 21.
Compared to retirement accounts and 529 plans, UGMA/UTMAs offer flexibility. While trusts may come with specific stipulations regulating the beneficiary’s use of or access to assets, and 529 plans can only be used for educational expenses, the beneficiary of a UGMA/UTMA can use the assets freely once they take control of the account.
There are several reasons you may consider opening a UGMA/UTMA for your child or grandchild:
- You may want to jumpstart your child’s experience with investing,
- Or create a way for them to afford educational expenses,
- Or use the account as a way to reduce your taxable estate
But it’s important to keep in mind there are potential downsides to utilizing a UGMA/UTMA account to invest for a child, too:
- The contributions are irrevocable, once you’ve made a contribution to the account you can’t undo it!
- The funds are flexible to be used as the child sees fit once they become an adult – regardless of if they will use the funds responsibly
- There are no tax advantages to this type of account like there are with other options like a 529 plan.
Roles Related to the Account
There are three parties involved in the creation, management, and receipt of a UGMA/UTMA account.
- Donor(s) – the person or people who make contributions to the account. While this is often the person who set up the account, maybe a parent or grandparent of a child, friends or family members can also contribute to UGMA/UTMA accounts. Even the underage beneficiary can make contributions!
- Custodian – the person or financial institution who can purchase investments on behalf of the beneficiary. The custodian can be the same person as a donor!
- Beneficiary – the underage person who receives the contributions of the account, and who takes control of the assets in the account when they reach adulthood.
Contributions
UGMA accounts can hold financial assets, like cash, stocks, mutual funds, and bonds. UTMA accounts can hold financial assets, along with a broader range of assets such as real estate, art, intellectual property, etc.
There is no annual or lifetime contribution limit to a UGMA or UTMA account, although contributions to the account are subject to the gift tax (more on that here). There are no tax deductions for making contributions to a UGMA or UTMA account.
And, importantly, as soon as a contribution is made to a UGMA or UTMA account it becomes the property of the beneficiary – even before they take control of the account. Contributions are irrevocable, they cannot be reversed. Any earnings on the assets in the account are also the property of the beneficiary.
Withdrawals
An appealing element of UGMA/UTMA accounts is that there are no withdrawal penalties. While the custodian of the account still manages it as the beneficiary waits to reach the age of majority, the custodian can withdraw funds to be spent on behalf of the beneficiary without penalty. For example, funds may be withdrawn to purchase school supplies or a car.
Once the beneficiary reaches the age of majority and takes control of the account, the account must be transferred into the beneficiaries name and all of the assets are immediately available to them to be used however they choose.
Taxes
Because the earnings of a UGMA/UTMA account are owned by the beneficiary, the earnings are taxed according to the Kiddie tax. Per year, a child’s first $1250 of unearned income is tax free. Their next unearned $1250 is taxed at the child’s tax rate, and all unearned income above that is taxed at the parent(s)’ tax rate. Unearned income includes interest, dividends, and capital gains. The principle of a UGMA/UTMA won’t be taxed.
More to Know
It is important to be aware that, because the assets are owned by the beneficiary, the assets of a UGMA/UTMA account can impact a student’s eligibility for need based student aid (FAFSA). This is true about 529 plans as well, but to a lesser degree.
It’s also the case that the custodian of an account can be changed, for example, a grandparent who has setup a UGMA/UTMA account for their grandchild, could pass down that account to the parent of the child to manage until the child reaches the age of majority.
Because UGMA/UTMA accounts are so flexible, it’s important to note that the beneficiary will receive access to all the assets in the account when they reach the age of majority no matter what - regardless of if they will use the funds wisely.
There are no tax benefits to a UGMA/UTMA like there are with 529 plans. They can however be invested for tax efficiency.
Case Studies
Situation #1: Joe sets up a UGMA account for his granddaughter daughter Margo when she is 5 years old. Joe makes contributions to the account over the next 16 years and it grows to a sizeable balance. When Margo turns 21, she uses half of the available funds for a down-payment on her first house.
Situation #2: Caroline sets up a UGMA account for her son Mark when he is 5 years old. Over the years, Caroline makes regular contributions to the account and it grows to a sizeable balance. When Mark turns 21, he gains access to the funds and quickly spends the money on a car and a few vacations. The funds are depleted within one year.
Important Disclosures:
Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.
Case studies presented are purely hypothetical examples only and do not represent actual clients or results. These studies are provided for educational purposes only. Similar, or even positive results, cannot be guaranteed. Each client has their own unique set of circumstances so products and strategies may not by suitable for all people. Please consult with a qualified professional before implementing any strategy discussed herein.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
Prior to investing in a 529 Plan investors should consider whether the investor's or designated beneficiary's home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state's qualified tuition program. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary. Please consult with your tax advisor before investing.