UTMA and UGMA custodial accounts

In short

A friend of mine once opened a small account for his niece and then spent a year wondering whose money it really was. Here is the plain answer. A custodial account is a bank or brokerage account held in an adult's name for the benefit of a child. The gift is final, and the money belongs to the child from the first day. The adult, called the custodian, manages it until the child reaches the age set by the state. The child then takes full control, whether the family likes the plan or not. The age is set by each state, so the bank or the state statute names the age for a given account.

The whole of it

What it is

I once watched a grandfather slide a savings book across a kitchen table and say, "This is for you, when you are grown." That small scene is most of what a custodial account is. UGMA stands for Uniform Gifts to Minors Act. UTMA stands for Uniform Transfers to Minors Act. Both are state laws that let an adult give money or property to a child without setting up a formal trust.

The two differ in a small way. The older UGMA mostly covers cash, stocks, bonds, and mutual funds. The newer UTMA allows more kinds of property, such as real estate, art, and other assets. Most states now use one of the two. A few states use both, so the bank can tell you which one applies to you.

The child is called the minor, and the child is the legal owner. The adult who runs the account is the custodian. The custodian can be a parent, a grandparent, or a trusted friend. The custodian has a duty to act for the child's benefit, not for the custodian's own.

How it works

If you are holding a little money for a child you love, you have probably wondered how the steps go, and they are plain. The custodian opens the account at a bank or brokerage, using the child's Social Security number. Anyone can then add money. Aunts, uncles, and grandparents often do.

Every gift is permanent. The custodian cannot take the money back, and the custodian cannot move it to a different child. Think of it as a gift in a sealed envelope that the child will open at a set age.

The custodian may spend money from the account, but only for the child's benefit. A computer for school could qualify. A new truck for the custodian would not. Paying for things a parent already owes the child by law, such as basic food and housing, is a gray area. State laws differ on whether the account may cover those costs, and some courts have questioned such payments. A custodian who is unsure should ask a lawyer in that state.

When the child reaches the age of termination, the custodian must hand over the account. That age is set by state law and is often 18 or 21, though some states differ. The child may then spend it on anything at all. That is the part that makes a few parents lose sleep.

The numbers, and where to find yours

You have probably wondered about taxes, and that is fair. The child owns the account, so the child owes tax on what it earns. But a rule often called the kiddie tax can tax a child's unearned income at the parent's rate once it passes a certain amount. The yearly threshold is the current figure, which the official source publishes each year. The IRS explains this in Form 8615 and in its instructions.

Gifts have a tax side too. A donor can give up to the current figure, which the official source publishes each year per person each year without filing a gift tax return. The IRS lists this on its gift tax page and in Form 709 instructions.

Financial aid is the other number to watch. A custodial account counts as the child's asset when a college looks at aid. The federal aid form is the FAFSA, and the Department of Education's Federal Student Aid site explains how assets are counted. Because the child owns the account, it can weigh more heavily than a parent's savings. The rate is set by the formula for the aid year, and the current figure is posted on that site.

Your state's age of termination is the last number. Search for your state's UTMA or UGMA statute, or ask the bank that holds the account.

A worked example

Let me tell you about a woman named Rosa. She has a grandson named Mateo, who is six. Rosa gives him $2,000 for his birthday and opens a custodial account with her daughter Elena as the custodian.

Over the years, Rosa and Elena add $500 each year for eleven years. That is 11 years at $500 a year, which comes to $5,500. Add the first $2,000 and the total put in is $7,500.

Suppose the account earns 5 percent a year. That is an example figure, not a promise. The $2,000 gift grows for 12 years. Using the rule of compound growth, $2,000 times 1.05 raised to the 12th power is about $3,592. Now take the $500 deposits. Say each one goes in at the end of a year, from year 1 through year 11. The first deposit grows for 11 years, and the last one grows for 1 year. Together they come to about $500 times 14.2068, which is about $7,103, a figure this example rounds to the nearest dollar. Add the $3,592 to the $7,103, and the account reaches about $10,695 by the time Mateo is 18. The exact figure depends on real returns, which can be higher or lower.

Now say Mateo's state sets the age of termination at 21 and he turns 21. The custodian must hand over the whole account, so Elena must give it to him. If Mateo wants to buy a motorcycle with it, the law lets him. Rosa and Elena cannot stop him.

That story is why I tell people to talk with the child early. A child who understands the gift is more likely to treat it with respect.

Where it goes wrong

A neighbor of mine learned this one the hard way. He put money in a custodial account, then needed cash for a family emergency and took it back. That is not allowed. The money was the child's, and he had to put it back.

Control is the first trouble spot. At the age of termination, the child has full say. No parent, grandparent, or custodian can keep a hold on it, even if the child makes a choice that worries everyone.

Financial aid is the second. Because the child owns the account, a college may count more of it than it would count of a parent's savings. A family expecting aid can read the federal aid rules on the Federal Student Aid site to see how a large sum would be counted.

Taxes are the third. The child's earnings can be hit by the kiddie tax, and a custodian has to report them correctly. A mistake can mean a letter from the IRS.

The fourth is a switch of plans. The account cannot be moved to another child, and it cannot be turned into a trust later. If a family wants more control, a formal trust may fit better, and a lawyer can explain the cost.

The last one is the death of the custodian. If the custodian dies, a successor takes over. Many states let a custodian name a successor, but the rules and the steps differ from state to state, so the state's UTMA or UGMA statute or the bank holding the account can say what applies.

Questions to answer before you leave this page

Do you know what age your state sets for the child to take over, and are you comfortable handing a young adult the whole account on that day? Have you talked with the child, or with the child's parents, about what the money is for? Have you looked at how a college would count this account when it weighs aid, and does that change how much you plan to put in? Do you know who the successor custodian would be if something happened to you, and have you written the name down? Would a formal trust, drawn up with a lawyer, give you the control you really want? And have you checked the current yearly figures on the IRS pages for the kiddie tax and the gift tax exclusion before you give?