Considering Custodial Accounts
The UTMA Option
Parents who are turned off by regulations governing 529 and Coverdell account expenditures have another option. The Uniform Transfer Act (UTMA) has allowed for the creation of a savings account for minors, one without spending restrictions. The UTMA is a revised version of the previous Uniform Gift to Minors Act (UGMA) and has now been adopted by all but two states (South Carolina and Virginia continue to employ the UGMA).
The UTMA is a good alternative to having minors own stocks, bonds, or mutual funds—which they usually cannot. Through this account, gifts are passed down to minors who may legally take advantage of them once they reach maturation age (depending on state, this may range from 18 to 21). In the meantime, the child’s custodian oversees the account. Because the money is a gift to the minor, the custodian may only use it to pay for the minor’s expenses. In contrast to the 529 and the Coverdell, such expenses are not restricted to educational expenditures—as long as they are of benefit to the child. Examples of acceptable expenditures include camping trips, tutoring, and a dance lessons. Expenses that are normally expected from a custodian, e.g., food, clothing, housing, and medical expenses, are not considered to be valid expenditures.
Once a child takes over the account, they have no restrictions on spending decisions. This may be a plus if a child decides to be the next John Mayer vs. the next Einstein—or if they have needs besides dictionaries. However, if there is uncertainty about a child’s ability to make responsible financial decisions, this account may not be a good choice. The account belongs to the child. It cannot be returned to the giver, and it may not be rolled over to a sibling’s account. Once again, whether this is viewed as a benefit or deterrent depends on the person.
The money earned in a UTMA, unlike that deposited into a 529 or Coverdell, is taxable. However, there are still tax incentives that make the UTMA appealing. As long as the child does not have a large income, they may be charged little or no tax. The first $950 dollars earned each year is not taxed for kids up to 18 years of age. The next $950 is taxed at a child’s rate — which is generally lower than the tax rate of adults. When the yearly earnings exceed $1,900, the funds are taxed at adult rates. These tax incentives are not as good as those provided by the Coverdell and 529. On the bright side, the yearly $2,000 Coverdell contribution cap is not in place for the UTMA, which has unlimited growth potential.
The biggest downfall of owning an UTMA is its effect on college financial assistance. Because the UTMA is owned by the child, it may significantly lower government aid. It is more economically efficient to be taxed on assets owned by the parent than it is to be taxed on the student’s assets. Whereas it is assumed that about 35% of a child’s assets will be set aside for college, 5.6% of the parent’s assets are assumed to be used for a child’s education. This can prove to be a big drawback once students apply for aid.
If one wants to save money for college and is unsatisfied by expenditure restrictions placed on 529 and Coverdell plans, the UTMA is a good option. One should keep in mind that all eggs need not be placed in one basket. A parent may set up a 529 or Coverdell account in their name while maintaining a separate UTMA account. Also, UTMA savings may be rolled over to a 529 account— although additional UTMA-like restrictions may govern that rollover. It is best to consider one’s priorities before committing to one savings account, or more.
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