UTMA/UGMA Custodial Accounts
Over the years, Uniform Transfers to Minors and Uniform Gifts to Minors custodial accounts (also known as UGMA and UTMA accounts) have become less popular than college savings options. The change is due to the increasing popularity of Coverdell Education Savings Accounts (Coverdell ESA) and Section 529 plans, both of which were created by the government specifically to offer tax advantages for parents saving for their child's education.
UGMA and UTMA Accounts Today
You can choose to create a custodial account in order to save money toward your child's college expenses. You can invest any money contributed to the account, allowing your child to earn additional money toward his or her education. You can choose from a wide variety of investment options with an UGMA or UTMA account, unlike with some other college savings vehicles. For instance, if you choose to invest in growth stocks through the account, your child may be able to earn more than with a Section 529 plan.
However, earnings from an UGMA or an UTMA custodial account are taxable. In the past, earnings on custodial accounts were taxed at the child's rate — typically, a child is in a significantly lower tax bracket than a parent, offering tax savings. However, due to changes in the tax laws in 2006, children cannot take advantage of their own lower tax brackets until they turn 18. Taxes on an UGMA or UTMA custodial account will be at your rate, rather than your child's. Furthermore, in many cases, if your child is a full-time student and your dependent, the custodial account may still be subject to taxes at your level.
Custodial Account Limits
With an UGMA or UTMA custodial account, you can contribute up to $12,000 to your child's account in any given year without triggering the gift tax, as long as that contribution is meant to pay for future higher education expenses. Other individuals can also make contributions up to the same limit: if a grandparent wanted to contribute to an UTMA or UGMA account, the limit is still $12,000 per individual. These limits put less constraints on what you and your extended family can save for your child's education than other college savings vehicles.
In some cases, a relative can simply contribute investments or securities to a custodial account, rather than contributing money. While such a gift may not be particularly advantageous to a child in terms of taxes, it can have positive income tax considerations for the giver. The specifics of laws governing UGMA and UTMA accounts can vary by state.
Control of Custodial Accounts
One consideration that may affect whether you'd prefer to use an UGMA or UTMA custodial account is the fact that upon becoming an adult, your child will have full control the account. Depending on the state, custodial accounts are turned over when your child turns either 18 or 21. Technically, this means that if your child chose not to use those funds toward college expenses, your options would be limited.
Furthermore, since UGMA and UTMA accounts are legally the property of your child, they can be problematic when applying for financial aid. Most colleges weigh assets belonging to students more heavily when considering what a student and his or her parents will be able to pay toward college expenses. That means that a custodial account meant to help your child with paying for college can actually minimize the amount of financial aid he or she will qualify for. In contrast, a Section 529 plan or a Coverdell Education Savings Account is considered a parental asset and does not have as significant an impact on financial aid packages.