For parents seeking tax-advantaged strategies for transferring funds to their minor children—whether as a way to save for college or simply to give their kids a financial head start when they become adults—a popular type of custodial account called a UTMA account may provide a solution. However, understanding the tax implications of UTMA accounts is important when deciding whether they are the best option for your family.
What are UTMA accounts and how do they work?
Typically, children under 18 are not legally eligible to receive assets, but the Uniform Transfers to Minors Act (UTMA)—an expansion of an earlier law called the Uniform Gifts to Minors Act (UGMA)—provides an exception. Adults can easily open a UTMA account and contribute assets, which may include securities, real estate, life insurance policies, and other items of value, on behalf of a minor beneficiary.
An adult custodian—often a parent—manages the assets in a UTMA account until the minor turns 18 or 21, depending on the state. As the custodian of a UTMA account, you can spend or invest the funds as you see fit, as long as your actions are taken for the minor’s benefit; funds contributed to a UTMA account cannot be taken back or used for the benefit of anyone else in your family, including another child. Qualified uses of the funds may include expenses for the beneficiary’s education, transportation, and extracurricular activities. Once the minor becomes a legal adult, you will no longer have any control over how the assets are used—which could potentially present a problem if you opened the account hoping that your child would use it to pay for higher education or another specified purpose.
Tax implications of UTMA accounts
Since UTMA accounts are funded with after-tax dollars, withdrawals are not taxed. However, unearned income—such as interest, dividends, and capital gains generated by assets in the account—may be subject to taxation. Currently, the first $1,100 of unearned income is tax-free. The next $1,100 is taxed at the minor beneficiary’s rate, which is often zero; at this point, you generally must file a Form 1040, and possibly a state income tax return as well. In addition, you will need to file a gift tax return if you transfer more than $15,000 to the account in a given year. Gifts over this amount will also count against your $11.7 million estate tax exemption.
Prior to enactment of the Tax Cuts and Jobs Act (TCJA) of 2017, unearned income over $2,200 was taxed at the parents’ marginal tax rate. However, the new law applied the so-called “kiddie tax” to UTMA accounts, meaning that income over the $2,200 threshold is now taxed at the rate of estates and trusts—which may be as high as 37% for interest income and short-term gains, and 20% for long-term gains and dividends. As a result, UTMA accounts are generally not as advantageous from a tax perspective as they were prior to the TCJA. While there may be exceptions—for example, if your child is a full-time student, you may be able to claim their income on your own tax return—it’s important to consult a tax or financial advisor to determine how these accounts would work for your family. Alternative arrangements, such as 529 plans or trusts, may provide more control over how the funds are spent and greater tax benefits, depending on your circumstances.
To learn more about UTMA accounts and their tax implications, contact our team today!
–Stephanie Vance, J.D.
(Sources: https://www.marketwatch.com/story/why-parents-should-think-twice-about-using-custodial-accounts-to-save-for-their-kids-college-2019-04-22, https://www.policygenius.com/retirement/utma-account/#how-is-an-utma-account-taxed, https://www.thebalance.com/beginners-guide-to-ugma-and-utma-custodial-accounts-4060475).
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