Accounts established under the Uniform Gift to Minors Act (UGMA) are predecessors to the now popular Section 529 plans and Coverdell ESA’s. Because of strict laws involving the rights of a minor to contract, children cannot own stocks, bonds, mutual funds or life insurance policies. Accordingly, parents must transfer such assets to their children through the use of a trust.
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Purpose of a UGMA
The most common trust account, which does not require the use of an attorney as such terms are established by state statute, is a custodial account or UGMA. The Uniform Transfer to Minors Act or UTMA is similar to a UGMA but also allows minors to own other types of property such as real estate, fine art, patents and royalties, and for the transfers to occur through inheritance.
The purpose of a UGMA account is to serve as a custodial account to hold and protect assets for a minor until he/she has reached reach the age of majority, which is between 18 and 21 depending on the state.
Such accounts can most often be opened through a brokerage institution, such as an online discount broker and the donor must appoint a custodian or trustee. The assets in the account are irrevocably gifted to the minor i.e., cannot be taken back. Further, there are no maximum contribution limits. The donors, should, however, be aware how such contributions impact their annual/lifetime gifting limits for tax purposes.
How UGMA Accounts Work
The custodian or trustee, normally the parent or donor, oversees the account, makes investment decisions (perhaps in conjunction with a financial advisor) and maintains a fiduciary responsibility to manage the assets in a prudent way. The custodian may make certain withdrawals from the account to cover expenses which benefit the child (beneficiary) including school fees, tutoring, computer, equipment, etc.
Withdrawals are not limited to college costs but should be used for a child’s education needs. Once the minor comes of age, the trust terminates; at which point, the beneficiary may use the funds in any way he/she desires.
One significant reason that such accounts are popular is a result of their tax benefits; UGMA accounts receive the advantage of the “kiddie tax” which allows a certain amount of a minor’s income to go untaxed, and an equal amount to be taxed at the child’s tax rate (as opposed to mom and dad’s rate).
UGMA and Taxes
According to the CollegeWithinReach.com website, the first $1,050 of earned income from investments in a UGMA is generally tax-exempt and subsequent income up to $1,050 is taxed at the child’s rate, which will most likely be nominal. These tax rules are for earned and unearned income for a minor.
This means that any sale or exchange of stocks, mutual funds, etc. can result in a capital gain or loss which may have to be reported on the minor’s tax return if the gross sales amount combined with other income is high enough. Any income earned over $2,100 is taxed at the parent’s rate.
For financial aid purposes, assets in a UGMA account are considered to be those of the beneficiary/“student’s” and may impact the amount of financial aid the student receives.
Many families consider UGMA custodial accounts when looking to save for a child’s education. While the flexibility and tax savings it offers are attractive, it is important to take into consideration the impact it may have on financial aid eligibility.
Before opening a UGMA account it is important to learn about both the advantages and disadvantages that such an account may offer as well as college saving plan alternatives including 529 plans and Coverdell ESA’s. Nevertheless, saving early for a child’s education is never a bad idea especially as college tuition continues to increase.
Please consult with a tax professional before making any decisions about a UGMA.