UTMAs – The Benefits & Challenges of Child Custodial Accounts

April 28, 2021

Planning & Saving

R’ Shneur Herman received a letter from an attorney informing him that a deceased relative had left his family $50,000 worth of stocks. The letter further explained that to manage tax ramifications, Shneur could consider transferring the assets to UTMAs accounts for his children. Shneur didn’t know UTMAs from bananas, but as a rebbi, he did know that he had to manage his taxable income and assets carefully since even a small financial shift could minimize the tax credits and social assistance his family needed to make ends meet.

What are UTMA accounts, and what are the pros and cons of using them to hold children’s assets?

UTMAs 101

Most parents come across UTMA accounts sooner or later. (UTMA, or the Uniform Transfers to Minors Act, is the 1986 legal verbiage guiding the usage of child custodial accounts.) Few people know their ins and outs, which is a pity because these child custodial accounts can effectively lower taxes or increase credits and perhaps social assistance eligibility for parents. On the other hand, there are UTMA pitfalls for the unwary. Reading the UTMA “manual” is essential to get the benefits of this unique financial tool while avoiding potential fallout.

Defining UTMA

Young kids can’t legally sign binding documents or open bank accounts for themselves. The point of UTMA accounts is to provide an easy path for parents (or any adult) to transfer and manage assets for underage children.

Before UTMA (and its predecessor, UGMA), parents had to either keep ownership of assets meant for their children, leading to unnecessary tax and legal complications, or hire attorneys and accountants to open costly and complex legal trusts naming the children as beneficiaries. Thanks to UTMA laws, parents can easily put money or investments in their kids’ names and reap significant tax benefits.

How Custodial Accounts Work

UTMA accounts are easily opened at most banks and investment companies. Within these custodial accounts, adults irrevocably transfer ownership of assets to the named child. Although immediately transferred, the child can’t touch the funds before they reach the state’s age of maturity (21 in NJ, NY, FL, and many other states, but 18 in CA, MD, MI, and some others).

Until then, the funds are the custodian’s responsibility, as selected by the one who opened the account. The custodian may invest the assets or spend as much of the custodial property as the custodian considers advisable for the use and benefit of the minor.

UTMA Tax Benefits

Because UTMA assets legally belong to the child, taxable income accrued from the account is treated differently than income belonging to the parents. More specifically, in 2024, up to $2,600 in annual investment income per child can be tax-free. (The first $1,300 is included within a standard deduction, and the next $1,300 is taxed at a 0% capital gains bracket, assuming the child doesn’t have salary or “earned” income.) Multiply that $2,600 by 5 or 10 kids, year after year, and it’s real money.

Income above that cutoff is generally taxed at the parent’s rate (the “kiddie tax”). But even so, as UTMA income accrues for the child, it won’t put the parents above the earned income tax credit threshold.

As mentioned, once the child ages out and becomes financially independent, the assets must be transferred to the new adult’s name. Depending on the child’s maturity and the parent relationship and trust level, the child’s legal rights to a bucket of money may be perfectly fine or perfectly disastrous.

Either way, at this point, there’s often another tax-saving option: the possibility to remove capital gains from UTMA accounts at a 0% tax bracket. As always, it’s worth running any tax ideas by your tax adviser—especially since UTMA accounts can have negative financial consequences in some scenarios, too.

No Backsies

The tax benefits of UTMAs stem from the irrevocable gifting of the assets to the child. However, for the same reason, the custodian must use UTMA assets only for the named owner’s benefit. So months or even years down the line, should the parents need the money for themselves or another child, they can’t just legally take it.

Generally, no one is really watching out for these things, and the kids often don’t know and simply trust their parents. There are legal loopholes, too. But the law is the law. There have been lawsuits over the misuse of UTMA funds, generally brought by divorced parents against ex-spouses. Next week, we will discuss some of those flexibilities and loopholes for tapping into UTMAs legally.

College Conundrums

A much more common UTMA challenge is the loss of college grants. Since UTMA assets are legally the child’s (who presumably doesn’t need them for daily expenses), funding calculations penalize these assets much more heavily than if they would be the parents’.

Maintaining assets in UTMAs can lead to the loss of thousands of dollars worth of Pell Grants, which can otherwise defray the cost of beis medrash or seminary. And even if parents can legally remove assets from the UTMA, the funding formulas may have a two-year look-back period in which assets removed from a child’s name still count against eligibility. Finally, removing the assets can itself create some tax issues.

One Tool of Many

Because of these UTMA challenges, some avoid them if possible. Multiple other alternatives for tax mitigation exist, including retirement accounts, life insurance, 529 college savings accounts, health savings accounts, and tax gain harvesting. But UTMAs still have their uses and the upsides of utilizing them may often outweigh their downsides.

Unfortunately, the tax code is complicated, and its navigation requires study and, usually, hiring professionals. But since there’s real money at stake, jumping through these hoops is well worth it.