In the U.S., there are two main types of custodial accounts for minors: UGMA accounts and UTMA Accounts. So what is a custodial account and what is the difference between a UTMA account and a UGMA account?
What is a Custodial Account?
In many jurisdictions, minor children are not able to enter into legal contracts like an adult can. Therefore, minor children are not allowed to own certain types of assets in their own name.
If a parent, grandparent, friend, or other adult wants to transfer such property to a minor child, one option is to transfer the property in trust for the benefit of the child. However, trusts can be fairly complicated and expensive to set up and manage and may require the assistance of an attorney or an online legal service such as Nolo.
Another option is to transfer the property to a custodial account for the benefit of the minor, such as a UGMA account or UTMA account. Custodial accounts provide adults with the ability to transfer assets to a child without having to set up a trust. Compared to a trust, a custodial account is generally much cheaper and easier to create, understand, and manage (although a trust may provide more control, flexibility, and protection). Custodial accounts are commonly used to help teach children about managing money.
Custodial accounts are established under your state’s Uniform Transfers to Minors Act, or UTMA, or Uniform Gifts to Minors Act, or UGMA. State law, rather than a trust agreement, spells out the relevant terms and conditions.
UTMA Account vs UGMA Account
There are two types of custodial accounts, UGMA accounts and UTMA accounts.
The Uniform Gift to Minors Act, or UGMA, allows adults to transfer cash and securities to a minor. The specifics of UGMA vary by state.
The Uniform Transfer to Minors Act, or UTMA, is quite similar, but also allows for the transfer of other types of property to minors. A UTMA account is also generally more flexible than a UGMA account.
Setting up a Custodial Account
An adult can generally set up a UTMA account or UGMA account at a bank, mutual fund company, broker, or other type of financial institution for the benefit of a child, grandchild, neighbour, friend, or other minor of his or her choosing.
The adult who sets up the account also appoints a custodian to manage the account assets for the benefit of the minor until the account terminates. The custodian may be the same person who created the account or another adult.
Custodial accounts are generally titled as follows:
UGMA Account: (Name of Custodian) as custodian for (Name of Minor) under the (Name of applicable state) Uniform Gift to Minors Act
UTMA Account: (Name of Custodian) as custodian for (Name of Minor) under the (Name of applicable state) Uniform Transfer to Minors Act
Assets held in a custodial account become the property of the child as soon as the transfer to the UTMA account or UGMA account is completed, even though the minor cannot control the custodial property until later (generally upon reaching the age of majority).
Since transfers to a custodial account are irrevocable, the transferor cannot take the money back if he or she later has a change of heart or an unexpected expense arises.
The Account Custodian: Managing the Account
When setting up a UGMA account or UTMA account, the donor appoints an account custodian, who is similar to a trustee. The donor can designate him or herself or any other adult.
The custodian manages the account for the benefit of the minor and makes all investment decisions until the child reaches the age of majority or other date when the custodianship ends. Although the minor is the owner of the account, he or she cannot control the custodial property during this time.
The custodian may also use the account funds for the benefit of the minor child. The custodian has a fiduciary responsibility to manage the account assets prudently on the minor’s behalf. In general, funds are not to be used to benefit the custodian or parent.
Many parents open custodial accounts for their children and name themselves custodian. They use the account to teach their children about investing. For example, they may discuss the various investment options, set goals, and periodically review investment performance.
Tax Consequences of a Custodial Account
Contrary to popular belief, there are is no special tax treatment for a UTMA account or UGMA account. However, it is important to understand the tax consequences of custodial accounts.
Income Tax Consequences
A number of years ago, many parents would transfer assets to their children in custodial accounts. Since the minor child is the owner of custodial account funds, any income or gains generated in the account also belong to the child and were taxed at the child’s marginal tax rate rather than the parent’s (usually) higher rate.
The IRS obviously didn’t like this, so they enacted the Kiddy Tax. Under the Kiddy Tax, the unearned income of certain children that exceeds $2,000 (adjusted annually) is taxable at the parent’s, rather than child’s marginal tax rate. This makes it difficult to achieve significant tax benefits from transferring assets to a minor child via custodial account.
Depending on the amount of income generated in the UGMA account or UTMA account and any other income the child may have, the child may need to file his or her own federal (and possibly state) income tax return and taxes may need to be paid. If certain requirements are met, the child’s parents may elect to report the child’s unearned income on their own tax return.
Gift Tax Consequences
Transferring assets to a custodial account is generally a completed gift for federal gift tax purposes. Each year, each parent can generally transfer up to $14,000 (indexed for inflation) to each child or any other recipient (via custodial account, trust, outright, etc) without using up any of their gift tax exemption, paying gift taxes, or having to file a gift tax return (provided certain conditions are met).
This means that a married couple could transfer $28,000 to each of their 3 children this year, next year, and each year after that without any real gift tax consequences. Should you transfer more than that in any year you will likely have to file a gift tax return and you will either use up some or all of your gift tax exemption or pay gift taxes.
Estate Tax Consequences
If you are wealthy, you may not want to transfer assets to a UTMA account or UGMA account and name yourself as the custodian. If the custodian dies before the account terminates, the value of the custodial account may be included in his or her gross estate for federal estate tax purposes. This may be avoided by naming someone other than the transferor as the custodian.
Terminating the Custodial Account
The termination date of a custodial account is generally when the child reaches the age of majority. This age is determined by state law and is generally between age 18 and 21. However, some states allow you to designate a different age within certain limits.
Once the custodianship ends, the beneficiary gains control over the account. The beneficiary may invest and/or spend the assets any way he or she chooses, without regard to the custodian’s (or parent’s, if different) wishes. The 18 to 21 year old could use the funds to pay for college, buy a flashy car, go to Vegas, or anything else he or she wishes.
What are your thoughts about custodial accounts? Have you ever used a UGMA account or UTMA account? Leave a comment below!