How to Use UGMA or UTMA Custodial Accounts for College

  Looking for alternative college saving strategies?  Interested in more flexibility to use funds for your student’s other financial needs? Consider a UGMA or UTMA custodial account.  Here’s how to use UGMA or UTMA custodial accounts for college.

Overview of UGMA and UTMA Custodial Accounts:

UGMA / UTMA accounts are considered the granddaddy of college savings accounts. Before Section 529 plans and Coverdell ESA’s, parents were successfully using these accounts to accumulate significant amounts of money for their children’s college.

The UGMA (Uniform Gift to Minor’s Act) and UTMA (Uniform Transfer to Minor’s Act) are nothing more than custodial accounts. A custodial account is used to hold and protect assets for a minor until they reach the age of majority in their state.

Because the assets are considered the property of the minor, these accounts are often used to take advantage of the “kiddie tax.” The kiddie tax 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).

Ideal Investor:

A custodial account is ideal for a parent or grandparent who:

  • Isn’t worried about the assets going to the child if unused (because they will without any strings if there are any leftovers)
  • May want to use the money for pre-college education or expenses (like tutoring, exam prep, college applications, computers)
  • Wants greater investment options than a Section 529 account (and more flexible options that may cost less – think index funds)
  • Isn’t worried about getting “needs” based financial aid (because this will be an assessed asset)
  • Wants to lower their taxes on a couple thousand dollars in annual investment income (hint: a good way to get around the ‘kiddie tax’)
  • Wants to lower their eventual estate by using their annual gift tax exclusion.

Advantages and Disadvantages of UGMA and UTMA Custodial Accounts

Potential Advantages:
Aside from the requirement to hand over “control” of any remaining money to a child at 18 or 21, these accounts are extremely flexible. It’s basically up to the custodian (usually the parent) to determine how to invest the money and when to spend it on the child.

Use of this account can help (but not guarantee) that $1,000 of investment income (2014) will go untaxed each year, with another $1,000 being taxed at the child’s tax bracket (which for most is much lower than the parents’ tax bracket).

Potential Disadvantages:
The same tax benefit that makes custodial accounts attractive can also make them unattractive. After the first $2,000 (2014) in income potentially being sheltered from taxes, excess income is fully taxed at a parent’s marginal tax bracket. This would not occur in a Section 529 plan or a Coverdell ESA.

Additionally, the account requires a custodian to hand over control of the assets to the child at anywhere from age 18 to 21 (generally 21 in Massachusetts). While parents with a good relationship with their child might be able to coerce those assets into being spent on college, a strained relationship may present a problem. Lastly, a custodial account counts heavily against a student’s financial aid application, since it is ultimately considered an asset of the child.

You can set up these accounts online or through any qualified investment advisor.  For more information about your investment options, tax benefits and special considerations, please see UTMA/UGMA Part II in this series.