As a parent, you are always scouting for ways in which you can give your children the best possible life. This can be through education, a career, or financial security- the earlier, the better. Opening a custodial investment account such as a UGMA account is one of the ways of giving your child a head start in financial planning.
These accounts are a straightforward means of saving for your child’s future while still having some growth potential, providing flexibility.
What is a UGMA Account?
UGMA is another shorthand term for the Uniform Gifts to Minors Act, and it provides the custodian with ownership of financial assets including stocks, bonds, mutual funds, and cash belonging to minors.
Minors cannot contract; their legal ability to own investments does not exist. An adult custodian, such as a parent or guardian, actually runs the account until the child turns 18 or 21, depending on the state where he or she resides.
Unlike a traditional trust fund, which typically requires legal documents and court intervention, UGMA accounts are easy to establish and administer. They provide the vehicle for creating financial assets for your child while teaching them valuable lessons about investing and financial responsibility.
How a UGMA Account Works
A UGMA account holds and protects a child’s (the beneficiary) money or assets. The contributor of the said account, a donor, shall have the opportunity to appoint his or her custodian-who may himself or herself also be the said contributor, and even a third party, financial institution, a bank, savings bank, trustee, or other custodial entity. The said custodian of the account would be able to invest in different types of items, such as stocks, bonds, or mutual funds, in the child’s account.
Accounts for UGMA can be opened at banks or brokerage firms. Any family member, friend, and anybody else can put money into it. There are no limits to how much one can add, but the catch is that such contributions must be made with after-tax money; in other words, donors cannot claim a tax break for such deposits. After the money has been added, it is irreversible; the funds now belong to the child, and the transfer cannot be undone.
The funds may be withdrawn for the benefit of a child under a UGMA account. While usually made in a parent’s name, the funds saved are technically in the name of the child. There are no penalties, but because the account is technically in the child’s name, the balance may count as his or her asset when applying for college financial aid, reducing eligibility.
When the child reaches the age of majority in their state, normally 18 or 21 years, they attain full control over the account and may spend the funds as they please.
UGMA vs. UTMA: Understanding the Differences
You may have heard of UTMA accounts or Uniform Transfers to Minors Act accounts alongside UGMA accounts. While both serve similar purposes, they differ in what they can hold:
- UGMA accounts can hold only financial assets such as securities and cash.
- UTMA accounts can hold a broader range of assets, including real estate, art, and other tangible property.
If your primary investment goal is in financial instruments that include stocks, bonds, and other such investments, a UGMA is just the right one. Still, if you intend to transfer other forms of assets, it would be much more suitable in the case of a UTMA, though you have to check state regulations since not all states allow for UTMA accounts.
Who Owns the Assets in a UGMA Account?
When the custodian controls the UGMA account, he or she is not a real owner of money and assets. Contributions to this type of account are irrevocable; they cannot be withdrawn after a person contributed to the account.
At the time of attaining majority, he or she will have absolute control over the account and may utilize the money as desired.
This structure also offers parents a great opportunity and a great responsibility to guide their children in learning financial literacy so that they understand the value of long-term investing.
UGMA Account Limits and Tax Implications
UGMA accounts are funded with after-tax dollars; anybody can contribute – parents, grandparents, and so on. Individuals can contribute $16,000 per year or $32,000 for married couples in a year without any gift tax implications in 2022.
While UGMA accounts do not offer the same tax advantages as a 529 college savings plan, they do provide flexibility. However, there are tax rules to be aware of:
- The first $1,150 of unearned income in a UGMA account is tax-free.
- The next $1,150 is taxed at the child’s rate (typically lower than a parent’s rate).
- Any unearned income over $2,300 is taxed at the parent’s rate to prevent tax sheltering.
How UGMA Accounts Affect Financial Aid
The treatment of UGMA funds for college financial aid purposes can impact the FAFSA eligibility. As UGMA accounts are always assets of the child and not of the parents, they are taxed at a much higher rate than that of parental assets. The value of a UGMA account could be included in the expected family contribution as high as 20%, while parental assets may only be taxed at 5.64%.
This needs to be taken into account when planning for college since it might decrease the need-based aid amount a child would qualify for.
Pros and Cons of Opening a UGMA Account
Pros:
- Flexibility: Unlike a 529 plan, UGMA funds can be used for any purpose once the child reaches the age of majority.
- No penalties for non-educational use: If your child chooses a path different from college, UGMA funds can help with other life goals.
- Simple setup: No need for complex legal documents or court involvement.
Cons:
- Financial aid impact: UGMA accounts are considered student assets and can reduce financial aid eligibility more than parental assets.
- Limited tax benefits: Unlike 529 plans, UGMA earnings are not tax-free when used for educational expenses.
How to Open a UGMA Account
Setting up a UGMA account is easy and can be done through banks, brokerage firms, or financial institutions. One option is to open an account through this custodial account provider.
When opening a UGMA, consider the following:
- Compare the investment options: Various providers differ in their investment options, from mutual funds to ETFs.
- Understand fees: Some providers charge account maintenance fees or trading fees.
- Understand the age of majority in your state: This is when your child will assume control over the account.
Conclusion
An UGMA account may be an important source of financial security and flexibility for your child’s future. Be it for college, saving up for that down payment on your first house, or other major life junctures, the utility of UGMA accounts is unmatched in their accessibility and adaptability.
Compare UGMA accounts with other savings options such as 529 plans and ask a financial advisor if necessary, before making your decision. Finally, the savings vehicle will depend upon your goals, as well as the needs your child may require in the future.