I know why you’re here. It seems like everyone and their yoga instructors are getting 529 accounts for their future ivy leaguers. But you don’t necessarily want to trap the money you’re saving for your rug rat in an account with potential penalties if they decide to forgo school to become a social media influencer or reality TV star.
So you heard that UGMA or UTMA custodial accounts may be the answer. They have some tax advantages, you can invest in almost anything, and best of all, you don’t have to use it for college if you don’t want to. Or your kid’s SAT scores come back and you initially thought they accidentally left off a digit.
Though usually, you hear both UGMA and UTMA mentioned together, they are not exactly the same thing. But they’re different in the way that sorbet is different from sherbet… most people don’t care unless they’re extremely lactose intolerant.
First, what they stand for: UGMA is the Uniform Gifts to Minors Act. UTMA is the Uniform Transfers to Minors Act. What’s the difference between a gift and a transfer? My guess is the face you make while doing it, but for the purposes of these acts, nothing.
It’s enough to know that they are just laws that made a legal way to give assets to a minor who normally can’t enter into contracts due to their age.
Neither of these accounts were created specifically for college savings, but it quickly became a primary way to do so. When the UGMA account was first created back in the 1950s, this was one of very few tax-advantaged ways of saving for college.
The UTMA account built upon UGMA in the 1980s, but both were supplanted by much better college savings plans later.
What Are They?
For now, let’s talk about them like they’re the same thing and get into the differences later.
At their core, UGMAs and UTMAs are custodial accounts that behave like irrevocable trusts.
Now, what does that mean? Think of it as an account that you (as the custodian) have to take care of but that doesn’t really belong to you anymore or your kid for a period of time. When they reach a certain age it’s all theirs and it’s off to the races (hopefully not literally).
Let’s unpack that.
If you know anything about trust funds it’s probably that rich people have them and give them to babies or something. Well… yeah… but it’s better to think of them like a separate entity that can hold your money and use it for someone else’s benefit.
This does a couple of things we care about for our purposes. One, it keeps that money away from people trying to take it from you. It may be bill-collectors, creditors, or that litigious person who tripped on your Harvard-bound tike’s skateboard in the driveway. And two, it makes that entity taxable – potentially at a lower rate.
The fact that a UGMA/UTMA is irrevocable (as opposed to revocable) means that once the money is in there, you can’t take it out for yourself. The only person it can go to legally is the beneficiary, in this case, your child when they become an adult.
One key difference from regular trusts is that normally when you set up a trust, you set the terms. The state you reside in sets most of the terms in UGMA and UTMA accounts.
This means that you have to take care of the account until it becomes theirs officially. You have to see that any taxes are paid and that the funds are spent in the interest of the beneficiary.
What if you decide that family trip to Hawaii you spent the money on was really for the benefit of your child? Hopefully, your child, when they grow up, agrees because if not, they can literally sue that flower-print shirt off your back.
Also, you don’t have to necessarily be the custodian. You can hire an asset manager to maintain the account, whom your suit-happy kid can then sue.
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UGMA vs UTMA: How They Differ
The biggest difference between UGMA and UTMA accounts is that UTMAs allow for more types of assets. While UGMA accounts are typically limited to things you find in most IRAs like stocks, bonds, and mutual funds, UTMAs can also hold things like real estate, art, patents, and even cars.
Age of Termination
This is probably the area that is most misunderstood about UGMAs and UTMAs. There is a thing called “Age of Majority,” which is simply the age your child becomes a legal adult. For most states, this is 18.
Then there is the “Age of Termination,” which specifically for UGMAs and UTMAs is the age when the assets legally become the child’s. For UGMAs, they are the same. At 18, your kid can take the money and run – literally.
For UTMAs, the age of termination can be anywhere from 18 to 25, depending on your state laws. Some states even allow you to choose which age within that range. So if you suspect your kid will consistently fail the marshmallow test, and you want them to mature a little more before giving them the keys to the kingdom, a UTMA might be the better choice.
Also, know that Vermont and South Carolina currently do not allow for UTMA accounts at all.
How They’re Taxed
First, let’s talk about what’s kind of tax breaks you don’t get. Are the contributions tax-deductible? No. Is the growth tax-deferred? No. This means that if you get interest or dividends or any sort of annual payout from your investments, you have to pay taxes on them as you go.
Special Tax Rates
If your child is under 19 or under 24 and a full-time student, the parent can choose to report the UGMA/UTMA taxes on their income tax return, where there’s a certain amount of the child’s unearned income (interest, dividends, other annual payouts) that are taxed at the child’s rate.
The first $1050 is actually tax-free. The next $1050 is taxed at 10%. So far so good.
Now, above $2100 it used to be that the unearned income and short-term capital gains were taxed at the parent’s rate, but because of the TCJA of 2017 that money is now taxed at the “Kiddie Tax” rate, which is a whole other can of worms. And any parent knows that worms and kids can be a dicey combination.
Without getting lost in the weeds, the consequence is that if your UGMA or UTMA account has a little over $2100 in annual unearned income, it’s not so bad. In fact, you’ll probably pay the same or slightly less in taxes than before.
But if your investments start making serious money (i.e. over $9150 a year), your tax rate jumps to 35% or more. However, this does not apply to long-term capital gains rates, which currently are at 0%, 15%, and 20%.
I know that’s a lot to take in, but an easy way to look at it is that for modest amounts, UGMAs and UTMAs can have some tax benefits, but the more substantial the assets and gains, the less attractive these accounts are for tax purposes.
Due to new Kiddie Tax rules, UGMA and UTMA accounts are less attractive as a tax shelterTweet This
As College Savings
For many reasons, UGMA/UTMA accounts should be thought of as something that can ALSO be used for college savings, but not as the sole purpose. With college costs seriously becoming out of reach for a lot of people, going to college is not necessarily the given.
Little Tax Advantage
Compared to other college savings plans, these relics don’t hold a candle to them. With most other higher education savings vehicles being tax-free when spent on qualified educational expenses, tax savings is not the reason you’re getting a UGMA/UTMA account if college is in your kid’s future.
While you’re down here, let me hit you again. When applying for financial aid, the assets within these accounts are counted as a student asset on your FAFSA application. This means that it will be counted against financial aid at the 20% rate, not the parental 5.64% rate.
This is the main advantage of UGMA and UTMA accounts. Your child does not have to use it for college. They could use it all for beer… which, I suppose could be a disadvantage. But at least there’s no tax penalty for his or her raging bender.
One Additional Word
I’m just saying this because I care. If you ever talk to a “financial advisor” who tries to sell you on their UGMA or UTMA account as a great way to save for college without even mentioning a 529 account, punch them in the neck (figuratively of course. I can’t afford being sued right now).
It’s likely because they don’t offer a 529 and getting you to sign up for their UGMA or UTMA account is the only way they will make money off you. This happens.
Compared to a 529 Plan
Both UGMA/UTMA accounts and 529 plans can hold investments to save for the future. That’s just about where the similarities end. In almost every other way that matters, they are completely different.
Since this article is not specifically about 529 plans, I’m not going to go into the details here. But the following chart summarizes the key differences:
|Account Control||Custodian maintains control forever||Beneficiary gets complete control once reaching age of termination|
|State Tax Deduction||Most states offer either a tax deduction or tax credit for contributions||None|
|Tax-deferral||All taxes are deferred||Taxes must be paid if the account earns income in any given year|
|Taxable Distributions||No tax liability if the funds are used for qualified expenses||Gains and income are taxed, but at a potentially lower rate or capital gains rate|
|Investment Choices||Usually limited to a small group of index and mutual funds||Can hold a much greater selection of assets, especially UTMAs|
|Qualified Expenses||Funds must be spent on qualified educational expenses or taxes and 10% penalty is owed||Funds can be used by the beneficiary for any purpose|
|Financial Aid Impact||Parental custodial plans are counted at 5.64% against any financial aid||Assets belong to the student and are counted 20% against any financial aid|
|Tranferability||Funds can be transferred to any family member or in-laws at any time||Funds can only go to the beneficiary|
Who Should Get One?
Honestly, college is not for everyone. There’s a reason why 30% of college freshmen drop out after their first year. If there’s a good chance your child will not go on to higher education and you want a way to transfer assets to them that will help them no matter what they decide, a UGMA/UTMA account may be the way to go.
However, with the new Kiddie Tax rules, the prior appeal of sheltering these assets from higher tax rates in these accounts has mostly gone away.
As a Hedge
There’s no rule saying you can’t have both a 529 plan and a UGMA/UTMA account. There is a small window of opportunity where if the gains are limited, it’s free of taxes or at a greatly reduced rate. This is regardless of where the money is spent.
If you’re willing to deal with having to manage multiple accounts, you could open a relatively small UGMA/UTMA account as an additional option. Some may find this is more trouble than it’s worth.
Just remember that the federal gift tax limit applies across all accounts for each recipient. So this is not a way of increasing the annual tax-free gifting allowed for your children.
To Protect Assets You Intend to Give to Your Kids
Earlier I mentioned that these accounts can shield assets from creditors and others. That’s actually one of the benefits of the accounts being irrevocable. Creditors can’t usually get to it because it legally belongs to the child.
However, if their lawyers can beat up your lawyers and show that you opened the account specifically to defraud creditors, it’s still fair game. A court can garnish those delicious assets within your UGMA/UTMA.
You could also just draw up an irrevocable trust with a lawyer that accomplishes the same thing, but it’s usually much easier and considerably less costly to set up a UGMA/UTMA account with a broker like CollegeBacker.
UGMA and UTMA accounts are in a strange position. Because they were originally created so long ago, a lot has happened to make them relatively irrelevant.
Incredible college savings vehicles have been created in the years since, such as 529 plans and Coverdell ESAs. Also, newer tax laws such as the Kiddie Tax law now apply to UGMA/UTMA accounts, making them not as tax-friendly.
But because there are so many unique financial and tax situations out there, there will always be a pocket of people who may find things like these useful.