UGMA and UTMA accounts

UGMA vs UTMA: Which Is Better?

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A UGMA and a UTMA are two types of custodial accounts that parents and others can use to give financial gifts to minors. If you’re not certain if your child will attend college, these two options may be a good alternative to a 529 college savings plan. We will discuss both UGMA and UTMA in detail to help you make an informed decision about which account to choose to set your child up for a bright future.

What is a custodial account?

A custodial account is a type of investment account that an adult, known as the custodian, can open on behalf of the minor. The adult is typically the parent. Anyone can then contribute to this account throughout the child’s life.

How do a UGMA and a UTMA work?

The UGMA and UTMA are custodial accounts. Once the UTMA or UGMA has been set up, the custodian and other adults can contribute to the account until the child gains full control. The account can grow quite considerably during a child’s life due to compound interest. This can help set your loved one up for their future financial goals.

A contribution to a custodial account is irrevocable. This means that the gift can never be taken back as it becomes the property of the minor recipient. The custodian also cannot tell the minor how to spend the money in the account.

Once the minor reaches 18 or 21, depending on the state that you live in, the child gains full control of the account and everything associated with it. Once the minor has full ownership of the account, then they can choose to do whatever they want with the assets. For some parents, this isn’t a problem, but for others, if you want to have full control over how the money is spent, then a UGMA or UTMA may not be the best option for you.

While all of the funds belong to the minor, as his/her parent, you can withdraw money for legitimate expenses that benefit your child. Any earnings within the account such as interest are considered unearned income for the minor. This will be taxed at the child’s tax rate. 

What is the difference between a UTMA and a UGMA account?

The main difference between a UTMA and a UGMA is the asset makeup of the account. The UGMA contains only financial products such as stocks, bonds, and mutual funds. A UTMA can have financial assets and physical assets. Some physical assets include real estate, jewelry, and fine art. You could set up a trust to leave physical assets for your loved ones but a UTMA might be a better option if you don’t want to go through the process of setting up a trust.

The second difference is related to state adoption. A UGMA and a UTMA are governed by two separate laws.  The UGMA was passed in 1956 and revised in 1966. All states have adopted the UGMA allowing parents nationwide to use these accounts.

The UTMA started 30 years later. Vermont and South Carolina do not allow UTMA accounts. The state you reside in also sets most of the terms for UGMA and UTMA accounts.

What are the key benefits of a UGMA and a UTMA?

  1. Flexible use of funds: There are no restrictions on the money. The child can use the money for any purpose.
  2. No contribution limit: You can contribute as much as you want.
  3. A great way to teach about financial literacy: You can involve them in investment decisions and watch the money grow together. It can also teach them about the stock market, investing, and compound interest. 
  4. Custodial control: Until the child reaches adulthood, the custodian has full control of the account. The custodian makes the investment decisions and determines any special circumstances where the money may be withdrawn for the minor. However, every asset within the account is owned by the minor. This will give you peace of mind knowing that the child will benefit from your contributions.
  5. Tax efficiency: The income that is generated in the UGMA and UTMA accounts is typically taxed at the “kiddie tax rate”. This can lead to significant tax savings over time. 
  6. Easy to set up: The accounts are relatively easy to set up through a bank or brokerage firm. This makes it a convenient option if you want to start saving for your child’s financial future. 

What are the disadvantages of using a UGMA or UTMA account?

  1. Lack of control: When you set up a UGMA or a UTMA for your child, then you are essentially giving them control of the assets once they reach the age of majority. This means that they can use the funds for whatever they choose. You don’t get to decide how this money should be spent.
  2. Irrevocable transfers: Once the assets have been transferred to the custodial account, they become irrevocable. 
  3. Tax implications: Any income that is generated by the assets in the account will be subject to the “kiddie tax: if it exceeds a certain threshold. Also, once the child reaches the age of majority, the tax rates on the income generated from the UTMA or UGMA will be higher. 
  4. Impact on financial aid: UGMA and UTMAs can have an impact on a child’s eligibility for financial aid as the account is considered the child’s.
  5. Limited investment options: The accounts are limited in terms of investment options available if you open the UTMA/UGMA with a bank.

UTMA and UGMA benefits and cons

Benefits of UTMA or UGMA accountsCons of UTMA or UGMA accounts
FlexibilityIrrevocable gift
Easy to set upMinor gains control at the age of majority
No contribution limitsNo tax benefits
No withdrawal restrictionsReduced financial aid eligibility
A great way to teach about financial literacy.Limited investment options

What are the contribution limits?

There are no contribution limits for UGMA or UTMA. However, whoever is contributing to the account needs to be aware of gift taxes.

The federal government requires that people pay taxes when they send someone a monetary gift. The IRS allows individuals to gift up to $17,000 to any person per year without filing a gift tax return. Even if you do give someone more than $17,000, you will likely not have to pay any taxes because the IRS allows you to gift up to $12.92 million in your lifetime before paying gift taxes. 

Are UGMA/UTMA tax-deferred assets?

UGMA and UTMA accounts are not tax-deferred assets. If the minor is under 18, or a full-time student and under 24, the custodian can choose to report the UGMA/UTMA taxes on their income tax return.

What is the tax rate for a UGMA/UTMA?

The first $1,250 of unearned income is tax-free. The next $1,250 in earnings is taxed at the kiddie tax rate which is 10%. If the unearned income is more than $2,500 per year then the earnings are subject to the parent’s tax rate. It’s best to talk to a financial advisor or tax specialist to make sure you are aware of any taxes that you may incur.

UTMA vs UGMA vs college saving 529 plans

The 529 plan is a college savings account that many people use to save for their children’s college education. People who set up UTMAs or UGMAs are likely to have goals other than paying for their child’s college education. 

  1. What the money can be used for: One key difference between custodial accounts and 529 plans is that custodial accounts can be used for non-educational purposes, whereas 529 plans can only be used to cover qualified education expenses. Only cash contributions are allowed for 529 plans.

  2. Ownership: Another difference is that the custodial accounts are the child’s assets and the 529 plan is the parents’ asset. A 529 could potentially be redirected to another child while the custodial account could not. Custodial accounts give the child more freedom over what they want to do with the money.

  3. Financial Aid eligibility: UGMA and UTMA accounts are counted towards financial aid. The Free Application for Financial Student Aid (FAFSA) looks at both the child’s income and the parent’s income to determine eligibility for financial aid. FAFSA considers UGMA and UTMA your child’s assets so they will count the assets at a rate of 20% compared to 5.64% which is the parental rate.

    They consider a 529 plan an asset of the parents. This means that if you have a UGMA or a UTMA then you will receive less financial aid. If your income/net worth is enough to make your child ineligible for FAFSA then this information may be obsolete to you.

  4. Taxes: UGMA and UTMA always incur taxes in the year that you have earnings. However, if the money from your 529 plan is used for college or educational purposes, then you will incur no tax liability even on earnings.

Should I open a 529 or a custodial account for my child?

If your primary goal is to invest money for educational purposes, then a 529 plan might be the best option for you. However, if you want to gift money for purposes other than education, then a UGMA or UTMA might be a better option for you. You can also move money from an existing custodial account into a 529 college savings plan.

Should I open a UGMA or a UTMA account?

First, it’s important to check that both account types are available in your state. UGMAs are available nationwide but UTMAs are not available in South Carolina or Vermont. If you live in one of those states, then you will have to choose a UGMA.

In addition, it’s important to decide what assets you want to transfer to the minor. If you want to transfer cash, stocks, or bonds, a UGMA would fit the purpose. If you want to transfer real estate, or if you want more flexibility in how the assets are used, then a UTMA may be the better option.

Can anyone open a UGMA or UTMA account?

Any US adult resident can open or contribute to a UGMA or a UTMA account. The custodian and the person(s) making the gift may or may not be the same person.

How to open a UGMA or a UTMA account?

You can set up a UGMA or a UTMA through a financial institution or a brokerage firm. You will need to complete an application for a custodial account so you will need basic information about the minor such as name, birthday, and social security number. Once the account has been set up then the custodian will manage the account until the minor reaches the age of majority.

Some frequently asked questions about UGMA vs UTMA:

– Does a UTMA/UGMA hurt financial aid?

A UTMA/UGMA can hurt financial aid. The accounts are reported as assets on the FAFSA. 20% of the value of the account is expected to be available for college expenses each year. In general, the larger the account, the more significant the impact on financial aid eligibility.

– Does the parent or child file the taxes for the custodial account?

If the UTMA/UGMA account generates interest, dividends, or capital gains, then the income is typically reported on the minor child’s tax return (Form 8615 – Tax for Certain Children Who Have Investment Income). It is the parent’s/legal guardian’s responsibility to file the child’s tax return, report the child’s income, and pay any taxes due. If the child’s unearned income exceeds a certain threshold, the Kiddie Tax may apply.

Who owns the money in the account?

The minor is the owner of the money in a UTMA/UGMA.

– Can a parent withdraw money from a UGMA or a UTMA?

The custodians of UGMA or UTMA accounts are typically the parents. They can withdraw money from the account to pay for the minor’s expenses such as education and healthcare. It is important, however, that the parents can demonstrate that the withdrawals are for their son or daughter’s benefit.

As soon as the child reaches the age of majority, he or she will gain full control over the UTMA or UGMA account. At this stage, the parents are no longer able to make any withdrawals.

If you are going to withdraw from a UGMA or a UTMA account, then it’s important to think about the tax implications. Make sure that you consult your tax professional or financial advisor.

Can a parent close a UGMA or a UTMA?

A parent cannot close a UGMA or a UTMA. They are irrevocable accounts and they legally belong to your child.

– What happens to a UTMA/UGMA if the minor dies?

In the event of the death of a minor, the money in the UTMA/UGMA is typically payable to the child’s estate unless a beneficiary designation has been created.

What is the average rate of return on a UGMA or a UTMA account?

The expected rate of return is around 5-7%, if it is invested in a healthy mix of low-cost, diversified stock and bond funds.

Set up a UGMA or a UTMA in 2023!

If you would like to contribute to your loved ones’ future, a UGMA or a UTMA may be a good option. While the accounts are similar, there are key differences to consider. Your goals will ultimately determine what type of account you open. Talk to a financial advisor to help you decide which option may be best for you and your family. If you’re interested in a comprehensive financial plan, schedule a free discovery call today.

Best Financial Planner Washington DC

Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help professionals in their 30s and 40s achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.

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