What is a UGMA Account?
A Uniform Gifts to Minors Act (UGMA) is a special type of account that is utilized for buying financial assets in the name of a minor.
The act was initially established in 1956 and revised in 1966. This account is like a trust-fund in that the assets are pledge to your child, who is a minor, and the growth of the funds are not completely taxed at your adult tax rate.
The account is generally controlled by a parent on behalf of a minor, and the setup is cost effective and avoids the expenses of paying a lawyer to establish a trust account.
There are several different accounts that you can set up for a minor, each providing certain criteria that make them attractive.
Types of Accounts for Minors
- Trust Account
- Custodial Account
- 529 College Savings Account
- Coverdell ESA
- Guardian Account
A trust account is generally established by parents for children who are minors. The account allows a parent to give or leave money to a minor, and the use and management of the account are overseen by a trusted adult.
This occurs until the child reaches majority or a specific age above majority (such as 21). The benefit of a trust account is that parents can avoid paying the federal or state gift tax.
There are two types of common custodial accounts, UGMA, and UTMA (Uniform Transfer to Minors Act) accounts.
The difference between the accounts is that the UTMA account provides more time to control the funds compared to the UGMA account. Additionally, the UTMA account can hold non-financial assets such as real estate.
A 529 savings account is a post-tax savings account where funds can grow tax free if they are used for qualified educational expenses. This includes tuition along with room and board. It can also include books and computer expenses.
The contributions to a 529 education plan can also qualify for several benefits which may include deducting contributions from state income tax or matching grants, but they can have various restrictions or requirements which are state dependent.
The Coverdell ESA account is an educational savings accounts for minors that allow up to $2,000 per year in after-tax contributions to be contributed to the account in the child’s name.
hese contributions grow tax-deferred and may be used tax-free for qualified educational expenses.
If the money is not used by the time the child is 30, it must be given to the child or transferred to another family member that is a minor.
A guardian account can be for both minors and adults. These are accounts for people that are unable to manage their money because of physical or mental incapacity. You will need a court order to open a guardian account and the instruction in the order will describe how the funds will be managed.
A guardian account terminates when the order expires or when a minor
Rules of a UGMA Account
The process of setting up a UGMA account is relatively straight forward. You can set up a UGMA without the assistance of a lawyer. The funds that are gifted to a minor are subject to state and federal gift tax rules.
The tax benefits of a UGMA account have changed several times over the past 2-decades, reducing the benefits of a UGMA account. As of 2018, the UGMA provides a benefit for individuals under 19 (or 24 if a student).
The first $1,100 of earned income is tax free.
The second $1,100 of earned income is taxed at a minor’s rate (also known as the “kiddie tax” rate) and after $2,200 of earned income the tax-rate reverts to the parent’s rate.
Pros and Cons of a UGMA Account
The UGMA provides several advantages and a few disadvantages for both the parent and minors. The pros include:
- Allows a parent to continue to invest money for a child without holding legal ownership of the assets in the account.
- The UGMA accounts provide tax benefits for income earned under a specific threshold.
- The account provides flexibility in using the money on the child’s behalf compared to some savings accounts that are specifically geared to educational expenses.
The disadvantages include:
- If the child goes to college the funds are viewed as owned by the minor which can have a negative impact on financial aid.
- Parents will turn over control of the funds to the child when the child reaches the legal majority.
- There is no mechanism to transferring the money in the account to another child such as with a 529 or an ESA account.
How to Open a UGMA Account
You can open a UGMA account at a brokerage or a bank. Here are the steps.
- Describe the account owner – verify your identity and enter personal information.
- About your account – Set up account features and preferences, such as whether you want to receive financial documents electronically or by regular mail.
- Review & confirm – Review your selections, the customer agreement, and the terms and conditions.
- Fund Your Account
A UGMA account is a cost-effective way to set up an account for a child that is a minor. This account provides maximum flexibility for using the money in the account on the child’s behalf.
The UGMA provides special tax treatment, at a child’s tax rate, for a specific tranche of earned income, before reverting to the parent’s tax rate.
While the UGMA is the most flexible custodial account, it does have some drawbacks. If you plan to transfer large quantities of assets, a trust fund might be more efficient.
If you plan to use the money specifically for educational purposes, you will get better tax treatment using a 529 or ESA account.
The money that is placed in a UGMA account is earmarked for the beneficiary and cannot be changed to another beneficiary.
When the beneficiary reaches majority, the money needs to be transferred which shortens the time that the assets are under the parent’s control.