UGMA vs. UTMA: Which is Best?

January 6, 2021
financial literacy

Most adults want to set the children in their lives up for financial success. We all want our loved ones to have an easier life than we did, no matter how blessed our own lives are.

One of the best ways to do that’s to give a child a head start financially, setting aside money for them to use when they grow up.

There are two types of custodial accounts that are popular among parents and others who want to give financial gifts to a minor. They’re named after the laws they’re based on: Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA).

The two types of custodial accounts are very similar, but there are a few important differences between UGMA and UTMA accounts that could impact which you choose to use.

We’ll break down how they both work, the differences, and the benefits of each, so you can be confident you’re choosing the right investment account for contributing to a child’s bright future.

What is a Custodial Account?

A custodial account is a type of investment account that an adult — known as the custodian — opens on behalf of a minor. The custodian and other adults can contribute to the account throughout the child’s life.

Custodial accounts can hold a variety of different assets. They can all hold financial assets such as stocks, bonds, and cash. Certain custodial accounts can hold a greater variety of assets including real estate, jewelry, and artwork.

Any earnings within the account, such as interest, dividend income, or a capital gain, are considered unearned income for the child. They’ll be taxed at the child’s tax rate (aka the “kiddie tax”).

Contributions made to custodial accounts are irrevocable gifts. Once the money goes into the account, the gift-giver can’t take it back.

In some cases, a custodian may be able to withdraw money for the benefit of the child, but it can’t be to pay for the basic expenses associated with raising a child.

If at any point you’re considering withdrawing funds from a custodial account, it would be wise to consult a legal or financial professional to make sure you have a legitimate cause to do so.

Until the child reaches adulthood, the custodian manages the account and makes the investment decisions. Then, when the minor reaches age 18 or 21 (depending on the state you live in), the child gains full control of the account and the assets within it.

Once the child receives ownership of the account, they can do whatever they want with the assets within it.

Many parents, grandparents, and other loved ones use a custodial account as a way to save for a child’s college education expenses or future goals.

Opening a custodial account for a child at a young age goes a long way in helping them to reach future goals. Thanks to compound interest, a parent or another loved one’s contributions can grow considerably throughout the child’s life.

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Custodial accounts vs. 529 plans

A 529 plan is a college savings account that many families use to help fund a child’s college education.

There are two different types of 529 plans.

One, a prepaid tuition plan, exists only in certain states and allows parents to lock-in the price of their child’s higher education. These plans aren’t as common, and they come with additional restrictions.

Most people that use 529 plans opt for the second option: a savings plan. With this type of plan, parents and other loved ones can contribute throughout the child’s lifetime.

Like a custodial account, contributions to a 529 plan can be invested to help them grow even more. Most often, 529 plans offer select portfolios or target-date funds the account owner can choose from.

529 plans come with certain tax advantages. First, many states offer a state income tax deduction for contributions. (There’s no federal income tax deduction available at this time.)

Once the money is in the account, it grows tax-free, and the child can withdraw it tax-free for certain expenses.

An important consideration with 529 plans is that the benefits are only available if you spend the money on educational expenses.

If you use it for any other purpose, you’ll have to pay taxes on the money, as well as an additional penalty.

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Besides the tax advantages, the other primary difference between 529 plans and custodial accounts is that while the money in a 529 plan is considered the parent’s asset, money in a custodial account is considered the child’s asset.

As a result, a 529 plan won’t affect the child’s financial aid eligibility, whereas a custodial account might.

On the other hand, A 529 could potentially be redirected to another child (as it’s not officially the child’s money), while a custodial account cannot. If you want to be sure your contributions go toward the intended child, this can be a drawback of 529 plans.

While the financial aid and tax advantages of 529 plans sound attractive, this type of account can be a risk. When a child is young, there’s no way of truly knowing what they’ll want to do with their life.

Sure, maybe they’ll want to attend college. But they might instead decide to start a business or follow another career path.

If their money is tied up in a 529 plan, it’s not as impactful in helping them to reach their goals.

What is the Difference Between an UGMA and an UTMA Account?

UGMA and UTMA accounts are the two common types of custodial accounts that parents and other loved ones use to save for a child’s future. The two accounts are remarkably similar. But they’re governed by two separate laws and have different rules regarding the types of assets they can hold.

The Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA) were both a result of an interstate initiative.

The UGMA was passed in 1956 and revised in 1966. Each state has adopted a version of the UGMA, allowing parents nationwide to use these accounts.

The UTMA was adopted 30 years later. Unlike the UGMA, not all states have adopted the UTMA. Only parents in those states that have adopted the law can use this type of account.

Aside from the availability of these accounts, the only other real difference comes down to what types of assets each account can hold.

An UGMA account, the original custodial account, can hold financial assets such as individual stocks, bonds, mutual funds, index funds, cash, and insurance policies.

An UTMA account can hold all of the same assets as an UGMA account. But it can also hold physical assets such as real estate, fine art, and more.

When to Use an UGMA vs. an UTMA Account

Given the close resemblance between the UGMA and UTMA accounts, parents and loved ones might find themselves wondering how to choose.

First, it’s important to confirm that each account type is available in your state.

While UGMA accounts are available nationwide, Vermont and South Carolina still haven’t adopted UTMA accounts. If you live in one of those states, you’ll have no choice but to use an UGMA account.

The other consideration is the type of assets you hope to transfer to the child in your life.

In some unique cases, families might want an account that allows them to easily transfer valuable physical assets to their children. In that case, you’d need an UTMA account.

But for most families, an UGMA account provides them everything they need.

Parents and other loved ones can contribute monetary gifts for the child. Then, when the child reaches adulthood, they can use the assets within the account to pay for college costs, start a business, travel the world, or go after any other goal they have.

Benefits of Giving Through an UGMA or an UTMA Account

Custodial accounts are an excellent way to invest in a child’s financial future and help them reach their future goals. Whether it’s your child or another loved one in your life, UGMA and UTMA accounts come with many benefits.

No restrictions on the money

Perhaps the most significant benefit of custodial accounts is the freedom they grant the beneficiary.

There are plenty of other accounts families can use to invest for their children — 529 college savings plans and custodial retirement accounts are just two. But these accounts come with many strings. The child has to use the money for a very specific purpose or risk paying significant penalties.

Other types of accounts may also come with a contribution limit that is lower than loved ones want to contribute.

But with a custodial account, the child can use the money for any purpose, and there is no contribution limit.

If they grow up and decide to attend college, they can use the money in their custodial account to cover their costs. But for those who have other goals in mind or who earn scholarships to pay for college, they can use the money in their custodial account for anything.

A chance to teach financial literacy

Opening a custodial account for a child in your life is an excellent way to teach them about money. From a young age, you can talk to the child about the account and help involve them in the investment decisions.

Then, you can watch the money in the account grow together. This process will leave your child with lifelong lessons about how investing, the stock market, and compound interest work.

By discussing your child’s custodial account with them, you may also be able to inspire an interest and excitement for finances. This interest can help to guide the trajectory of your child’s finances, career, and more.

Custodial control

One considerable advantage of a custodial account is the custodial control and the asset ownership.

Until the child reaches adulthood, the custodial maintains full control of the account. They make the investment decisions and determine any special circumstances where money should be withdrawn for the child.

And while control of the account remains with the custodian until the child grows up, every asset within the account is the property of the child whose name is on the account.

As a loved one sending financial gifts to the child in your life, you can rest assured knowing they’ll truly benefit from your contributions.

With other accounts, such as a 529 account, you don’t know for certain that the intended recipient will actually end up with the money. 529 plans allow custodians to transfer money in the account to different beneficiaries.

One thing to keep in mind is that depending on the state in which you live, the child will take control of the custodial account at either 18 or 21.

While this might seem like a perk, some parents might have concerns with their 18-year-old taking ownership of a large sum of money. Research the UGMA and UTMA laws in your specific state to learn the age at which account ownership transfers over.

Gift tax

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In rare cases, a custodial account may come with some tax consequences. The good news is the chances of this are quite low.

The federal government requires that individuals pay taxes when they transfer a gift to someone else. This tax even applies to parents and other loved ones transferring money into a child’s custodial account. Luckily, there are exclusions in place to prevent most people from being subject to the tax.

Each year, the IRS allows individuals to give up to $15,000 to any other person without filing a gift tax return. Once you reach that $15,000 limit (or $30,000 for a married couple transferring gifts), you’ll have to file the return.

Even after reaching the gift tax exclusion, you likely still won’t have to pay the gift tax. The IRS allows each person to gift up to $11.7M in their lifetime before they must start paying gift taxes.

How to Open a Custodial Account

Have you decided to open a custodial account to save for your loved one’s future? Luckily, it’s never been easier to do.

EarlyBird offers a simple and innovative way for parents, family, and friends to invest in a child’s financial future using an UGMA account.

First, a parent or another loved one opens the EarlyBird account for the child. Once the account is set up, all of the people in the child’s life can quickly and easily contribute money through the EarlyBird app.

The account custodian can choose between five different ETF funds that range from conservative to aggressive. Every time a loved one sends a gift, the money goes into the portfolio selected by the custodian.

Plus, as loved ones contribute money to the account, they can leave a video message to go with their gift.

When the child reaches adulthood and takes ownership of the account, they’ll see all the videos in the memories feed. Not only will the financial gifts have a considerable impact on the child’s financial future, but the videos will serve as a special keepsake for the child to cherish for years to come.

Conclusion

UGMA and UTMA Accounts both accomplish similar goals, giving people a way to give financial gifts to a child without giving them immediate control over the assets.

This makes them a good way for parents, family, friends, and other loved ones to set a child up for financial success.

If you’d like to contribute to your loved one’s future, why not start contributing to an UGMA account for them today? We make it super easy for everyone to collectively contribute through the EarlyBird app.

Download EarlyBird on the app store today to start investing in the kids you love.

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