UGMA, UTMA and 529 Plans

A question often comes up amongst folks of a certain age regarding UGMA/UTMA accounts.  Namely, since many of our parents used them for us about a generation ago, are they still tools that we should be considering for our college savings for our kids today.  Or, perhaps of slightly greater complexity, if they already have a UGMA or UTMA account for their kids, what, if anything, should they do with them?

So what are UGMA/UTMA accounts, anyway?  UGMA stands for the Uniform Gifts to Minors Act, which was passed in 1956 to provide a uniform set of rules which individual States could adopt to make it more convenient for folks to transfer assets to minors.  In 1986, the UTMA, or Uniform Transfers to Minors Act expanded the kinds of assets which could be so transferred to minors, and the UTMA has been adopted by most States since.

In both cases, the account created under UTMA or UGMA is called a Custodial Account, and it has some characteristics in common with a trust.  Like a trust, it's a container into which assets may be placed for the benefit of one person (the child), but under the control of someone else (the custodian - usually the parent - in this case, rather like a trustee).  Similarly, like a (irrevocable) trust, once assets are transferred into the account, it is considered a completed gift for gift and estate tax purposes.  Unlike a trust, however, the rules for the use of the custodial account and assets are not as customizable by the creator of or donor to the account.  In particular, the custodian may take money from the account specifically for the benefit of the child - it may be used to pay for private school, for example.  It may not be used for things which are already the obligation of the parent, such as food and shelter.  And lastly, the control over the assets and account usually automatically goes to the child when the child reaches the age of majority, usually 18 or 21, though some states allow for a little more flexibility in this.  That means that if you set up a UTMA account for a child and the child doesn't go to college or otherwise spend the assets in the account according to your wishes, when the child reaches that specified age, he or she may use the money for anything he or she wants.  The traditional example of this is the kid blowing the money on a sports car.

So why did folks set up these custodial accounts so often?  One, as mentioned above, to get the assets out of the estate.  Two, because the child's tax bracket is likely lower than the parents', so to the extent that the assets produce income, that income may be taxed at that lower rate.  Three, asset protection -- if the parent gets sued, the child's assets are not vulnerable.  Of these, the primary driver was generally the taxation and in the years since then, that benefit has been whittled away mainly by what's called the kiddie tax.  The kiddie tax rule makes it so that unearned income belonging to the child and exceeding fairly low limits gets taxed at the parent's rate rather than the kids rate.

The downsides to the UGMA/UTMA accounts, however, are substantial.  As mentioned above, the kid may blow the money on anything he or she wants once he or she reaches a certain age.  But that's not the only downside!  Also as mentioned above, the tax advantages are a lot smaller than they used to be.  The accounts still generate taxable income, whether it's at the child's tax rate or, if large enough, via the kiddie tax, at the parent's rate.  Moreover - and this may be a big one, too - at least according to the current federal financial aid rules, assets in a UGMA account which belong to the child are counted, not surprisingly, as assets belonging to the child when computing the family's expected contribution.  Assets belonging to the parent are expected to be contributed towards college costs at a 5.64% rate while assets belonging to the student are expected to be contributed at a 20% rate.

529 plans, on the other hand, suffer from few of these problems.  Assets in a 529 plan grow fully tax-deferred and if used for educational expenses, the growth is actually tax-free.  That's vastly better than the tax treatment of UGMA/UTMA assets.  Assets in a 529 plan remain under the control of the owner of the account (usually the parent) regardless of the child's age or whether it's used for college or not -- and if the child doesn't go to college, the beneficiary may be changed so that someone else such as a brother or cousin may use that money for college or, ultimately, if not used for college, could be returned to the donor (subject to tax and penalty).  UGMA/UTMA assets, once given, are gone.  As far as the other benefits - 529s also get assets out of the estate as well, and provide some protection in case of lawsuit or bankruptcy as well.  Finally, 529 assets are considered parental assets in the federal financial aid formula, so the expected family contribution due to 529 assets is considerably lower than if the assets were owned outright.

So the bottom line is that for most folks nowadays generally will benefit very much more from a 529 than from the old UGMA/UTMA accounts.

Here's the final chapter in our story.  If you have already established a UGMA/UTMA account for your child, you cannot just take that money back and open up a new 529 account owned by you with that money.  Sure, in theory, the money's for the same purpose.  But in fact, a 529 owned by you gives you substantially more long-term control over the assets than a custodial account because, unlike the custodial account, you may change the beneficiary or even take the money back, whereas a custodial account is the child's asset and in the long run, belongs to the child to do with as he or she likes.

So what's the solution for folks who already have a UGMA/UTMA account?  The 529 providers allow you to create a "custodial 529" account.  That is, the UGMA/UTMA provisions still wrap around the 529, but instead of the UGMA/UTMA investing in regular assets, the UGMA/UTMA invests in a 529.  The owner of this 529 is now the child, rather than the parent as would be typical with normal 529s.  And because of the UGMA/UTMA restrictions, the custodian may not change the beneficiary - the child must remain the beneficiary.  And finally, when the child reaches age of majority, the child may take control over the 529 and liquidate it (and pay taxes and penalties if not used for education) or, at that point, change beneficiaries to someone else.  So it still suffers a little bit of the downside of regular UGMA/UTMA accounts.  But it still keeps the 529 tax benefits, which are potentially enormous.  And the final cherry on top, should you have a UGMA/UTMA and are considering moving it into a custodial 529 -- for financial aid formulas, it's treated as a parental asset, rather than the student's asset.  That final twist makes it a rather large exception to the general rules of financial aid, and is very much a benefit for those for whom financial aid may ultimately be a consideration.

Bear in mind that everyone's individual situation is unique and that there is no simple rule which necessarily applies to everyone.  We hope the above notes help clarify the situation regarding custodial accounts, 529s, and the hybrid, custodial 529s.  As always, we invite questions and corrections.  And we remind you that the above notes are for informational purposes is not to be construed as professional personalized advice.

One last note, we remind you to review our other note about 529s and, in particular, to be aware of the costs associated with 529 plans and the difference between buying a 529 directly from the provider as opposed to buying into a 529 through a broker  (the unfortunately sadly named "advisor-sold" plans), which often have very much higher fees.

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