UTMA Accounts for Minors
For the last few weeks, we've been talking about savings vehicles for minors. We've gone over Roth IRAs and 529 College Savings Plans. If you missed those episodes, you can catch up anytime at luminarywealth.com/resources.
Today, we'll go over a special kind of custodial account called a UTMA that you can start for your children, grandchildren, godchildren, nieces, nephews, pretty much any minor you know! Are you ready? Let's get started!
WHAT IS A UTMA ACCOUNT?
UTMA stands for Uniform Transfers to Minors Act. It is an evolution from a similar act called UGMA, which stands for Uniform Gifts to Minors Act. The UGMA was originally developed in 1956, and allowed individuals to transfer assets to a minor beneficiary. It was a great tool to decrease the size of a wealthy parent's estate, and in some cases, avoid paying taxes at the parents' higher tax rate.
In 1986, the UTMA was born, and with it came some additional flexibilities on what can be gifted, and later on, it meant higher limits on the value of those gifts, but this legislation also closed loopholes that allowed parents to shelter money from the IRS. Every state except for South Carolina has adopted the UTMA and simultaneously repealed the UGMA, so going forward, we're only going to use UTMA terminology.
A UTMA, which is the current version, is a great "starter package" for your child to gift them money in their early years that they can access when they become a legal adult. It can also be spent on qualifying direct benefit expenses while the child is still a minor, which I’ll talk about in a minute. While your children or grandchildren are minors, you can be the custodian, or you can assign a custodian to manage the money. Gifts can consist of property, real estate, and inheritances, as well as cash, stocks or bonds.
WHEN DOES THE BENFICIARY GET CONTROL OF THE ASSETS?
When the beneficiary reaches the age of maturity, which varies by state, but is usually 18 or 21, the control of the account transfers to the beneficiary. This can affect the tax bracket and the total of the beneficiary's estate, which could adversely affect applications for college financial aid packages, so it's important to plan ahead of this major financial event.
Some strategies to reduce the impact on college aid eligibility could include depleting the account, always for purposes benefitting the minor, with purchases such as books, piano lessons, summer camps, a car, a down payment on a house they will live in during college, and other such directly beneficial purchases, so that when the child is ready to enter college, they have all the infrastructure they need, and they still qualify for financial aid packages. This isn't always the smartest strategy for every situation, so make sure you talk to a professional financial planner before you do anything with the money sitting in the UTMA.
Sometimes it's more beneficial to instruct the child to sit on that money, regardless of the tax and financial aid implications, if the account is so large that it can't be reasonably depleted, or the balance can reasonably pay for college. But be aware that there are tax implications to UTMA accounts, thanks to the Kiddie Tax.
HOW DOES THE DREADED “KIDDIE TAX” AFFECT A UTMA?
Let's hit on the Kiddie Tax for just a minute. While UTMA accounts are great for some things, tax sheltering isn't one of them. When Kiddie Taxes were first introduced in 1986, they were a slap in the face to many investors who had used their child's UGMA account to avoid paying taxes on excess assets. The government closed the loophole by creating a Kiddie Tax, so the government could get at some of the money being sheltered from the IRS.
Recent laws have adjusted this tax a little bit, and since the tax code is always changing, I'm only going to give you detail on what the law says right now, in the spring of 2021. If you're watching this video next year, or 5 years from now, these numbers may not be accurate anymore.
Before I dive in, just know that this gets into the nitty gritty a little bit, and while having this knowledge is really helpful, you should still consult a financial planning professional before you make any final decisions on where to put your child's money.
In order for the Kiddie Tax to even be a factor for your minor, all four of the following requirements must be met for the tax year in question:
The Child must not be filing a joint return.
One or both of the child's parents must be alive at year-end.
The child's net unearned income must exceed the threshold for the tax year, and the child has positive taxable income after subtracting any applicable deductions, such as the standard deduction.
The unearned income threshold for 2019 and 2020 tax years is $2,200. If the unearned income threshold is not exceeded, the Kiddie Tax doesn't apply. If the threshold is exceeded, only unearned income in excess of the threshold is hit with the Kiddie Tax. This threshold is the plug the IRS put in the loophole that people were using to shelter their wealth in their kids' custodial accounts.
The child or young adult falls under one of the following 3 age-related rules due to his or her age at year-end and the additional factors I'll mention along with each rule.
If the child is 17 years old or younger, the Kiddie Tax applies if the other 3 requirements are also met.
If the child is 18 and does not have earned income that exceeds half of his or her support, the Kiddie Tax applies if the other three requirements are also met.
If the child is 19-23 at year end and is a student and does not have earned income that exceeds half of his or her support, the Kiddie Tax applies if the other three requirements are also met. The child is considered to be a student if he or she attends school full-time for at least 5 months during the year. In the case of students, scholarships do not count as support.
SO WHAT IS THE KIDDIE TAX ANYWAY?
Well, under the Kiddie Tax, the IRS can collect taxes on net unearned income that your child owns, including assets transferred in a UTMA. This extra money is taxed at the parents' federal income tax rate. Like I said before, the Kiddie Tax plugs that loophole where people were sheltering money in custodial accounts for their children to avoid paying taxes on them. So a UTMA is not a good place to put money you don't want taxed. There are better, legal ways to go about avoiding Uncle Sam.
In calculating the federal income tax bill for a dependent child (or young adult) who is subject to the Kiddie Tax, the child is allowed to subtract his or her standard deduction amount. For 2020, the standard deduction is the greater of: (1) $1,100 or (2) earned income + $350, not to exceed $12,400.
WHY WOULD ANYONE USE A UTMA IF THERE ARE TAXES ON IT?
Well, there are some things a UTMA is really good for. Here are a few:
Paying for pre-college expenses that directly benefit the child and don't fall under your requirement as a parent to provide food, shelter and clothing. Things like piano lessons, travel soccer, and private school all qualify as reasonable expenses from a UTMA account.
Flexible gifts - most custodial accounts can only hold money, but a UTMA can hold real estate, so that can come in really handy at times.
Flexible spending - custodial accounts like a 529 or Coverdell Educational Savings Accounts can only be used for qualifying educational expenses. UTMA accounts don't have the same kinds of restrictions, so you can spend the money on a greater variety of things directly benefiting the child.
Generally speaking, a UTMA is great for smaller amounts of money that you want to have flexibility in spending. There are small tax advantages, and while they won't blow your mind, every dollar you don't have to pay to the IRS is another dollar you get to keep, so don't forget the UTMA when you are looking at paying for your kids' lacrosse uniform, again.
If you have large amounts of money to push off to your children, you might want to consider a trust instead of a UTMA, or break up some of the money in a 529, UTMA and maybe a savings account so you can teach your child the concept of Spending, Saving, and a Rainy Day fund. There really is no one size fits all solution because everyone's situation is just a little bit different, which is why speaking to a professional financial planner is always worth your time and your money. Having a fee-only professional in your corner will allow you to sleep at night because you know that professional has only one goal - to grow your wealth.
I know this is a ton of detail, so if you have any questions at all, don't hesitate to reach out to me at Lee@LuminaryWealth.com, or connect with me on LinkedIn or Facebook.
Keep saving, and have a great day!