Confused About UTMA Tax Rules? Here’s a Breakdown

One of the best ways to support the children in your life is to equip them for financial success.

For this reason, custodial accounts like the Uniform Transfers to Minors Act (UTMA) accounts were created. These accounts let adults and children work together to start the child off on the right financial foot.

However, with investments come tax consequences, even for children.

Below, we’ll explain UTMAs in more detail and explore various tax rules you should be keeping in mind when gifting money to or managing a UTMA.

To head straight to our breakdown of UTMA tax rules, click here.

What is a UTMA?

A Uniform Transfers to Minors Act (UTMA) account is a type of account that helps children start investing legally before they become adults.

Adults, such as parents, godparents, friends, and relatives, can gift money to the account to provide investment capital.

UTMAs, like other custodial accounts, have several key benefits:

• Help children build their assets early. Thanks to compounding, this can put them ahead of the game when they become adults.
• Help build generational wealth. The child might have significant assets to pass down by the time they grow old.
• Introduce kids to selecting and managing investments. They can learn some basic tax matters and have a solid understanding of money, investing, and wealth-building as they begin adulthood.
• Build great financial habits, such as setting aside a chunk of each paycheck to invest or save.
  

UTMAs may also help meet a child’s financial goals, like buying their first home, paying for college, or starting their own business.

UTMA vs. UGMA

UTMAs have a counterpart called Uniform Gifts to Minors Act (UGMA) accounts. Both UTMAs and UGMAs serve the same purpose, but there are some rule differences.

You can open a UGMA account in any state and use it to hold financial assets, like cash, stocks, bonds, mutual funds, and insurance policies for the children in your life.

The UTMA was created 30 years after the UGMA and has not been adopted in every state. However, it can hold all the same financial assets as UGMA, plus physical assets like precious metals and real estate. 

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How is a UTMA taxed?

Tax rules on custodial accounts like UTMAs are sometimes difficult to understand. 

UTMA accounts may be subject to taxes if the minor earns investment income or sells assets for a gain.

Plus, there are tax matters surrounding gifts and withdrawals. 

Let’s break down the UTMA tax rules for 2023.

Withdrawals

Withdrawal rules are a bit confusing. 

Contributions to UTMA accounts are made with after-tax dollars. Therefore, you can withdraw contributions tax-free, but with some caveats.

As you may know, anyone (parents, friends, relatives) can put money into a child's UTMA account as a gift. However, these are “irrevocable gifts.” Once the money’s in, only the account’s custodian can withdraw it. 

Also, since this money is legally the child’s, the custodian can only withdraw money on the child’s behalf and spend it on matters that would directly benefit the child. 

They can’t use it for day-to-day expenses like gas and groceries, but they could spend it on non-essential items that benefit the minor.

The custodian is a fiduciary, so they have to act in the minor’s best interest and consider the beneficiary’s wishes.

Under some circumstances, you can also transfer money to another custodial account for the child’s benefit, such as a 529 plan without being taxed or penalized. But, it becomes a custodial 529 plan and has somewhat stricter rules than a traditional 529 plan.

Investment income and capital gains taxes

The minor does have to pay taxes, as they are the owner of the UTMA account.

However, there are some benefits of the account belonging to the child and not the custodian. 

First, as of 2023, the IRS exempts $1,250 of the account’s passive income or gains from taxes each year. This amount increases almost every year to adjust for inflation. 

Then, the IRS taxes the next $1,250 at the account holder’s federal income tax rate. 

Since children don’t earn much, so this will probably fall into the 10% or 12% brackets for 2023. 

Just be aware that they can pay in higher brackets if they sell enough assets or make enough passive income in a year. 

Finally, the IRS taxes any income or realized gains over $2,500 at the parental tax rate — this is called the Kiddie Tax. 

The IRS created the Kiddie Tax rule to prevent parents or guardians from dodging taxes by placing assets in their children’s names. It applies to children age 19 or younger as well as to full-time dependent students under 23.

The Tax Cuts and Jobs Act changed this to the estate and trust tax rate for a few years, but Congress changed it back. 

That means the UTMA tax rules for 2023 involve the parental rate.

Let’s illustrate with some quick examples.

If your child earns $2,500 in their account in 2023:

• The first $1,250 is exempt.
• The next $1,250 would be subject to taxes at the child’s tax rate.
  

If they earn $2,600:

• The first $1,250 is exempt.
• The next $1,250 is taxed at the child’s rate.
• The $100 that exceeds $2,500 is taxed at the parent’s rate.
  

Keep in mind, children will only owe taxes when they sell an investment for a profit (capital gain) or receive unearned income such as stock dividends or bond interest payments. 

If they don’t receive any payments or sell anything, they won’t pay taxes, even if their assets increase in value.

The account holder can qualify for lower tax rates on some of their income under some circumstances. 

For example, selling assets held longer than a year puts the child at a lower tax rate for long-term capital gains. Qualified dividends are taxed at this rate as well.

Children can also take capital losses (when they sell an asset such as stock for less than they purchased it for), which they can use to offset any capital gains on the current year’s return. They may also be able to carry their losses forward to future years if they don’t have any gains to offset.

Gift taxes

The federal government requires people to report gifts of a certain amount to prevent them from moving assets around and dodging taxes. This includes gifts to a child’s UTMA.

In 2023, you can give up to $17,000 per recipient without reporting it to the IRS. For example, you could give $17,000 each to three UTMAs and not have to report any of it.

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Any amount above that threshold must be reported using IRS Form 709. You’ll also subtract that amount above the threshold from your lifetime gift tax exemption amount. In 2023 that amount is $12.92 million. 

When your lifetime amount hits $0, you begin owing federal gift tax.

For example, say you give $17,000 in 2023 to a child’s UTMA. No reporting is necessary.

Now, imagine you gift $17,500. You’d report $500 on Form 709 and decrease your $12.92 million lifetime amount by $500.

Keep in mind that states may tax gifts differently than the federal government. Make sure you know all state and local gift tax regulations before making a gift.

Contribution limits

There is no contribution limit for anyone when putting money into a UTMA account. 

Combining this with gift tax rules allows families to provide their children with a massive financial head start without worrying about taxes.

How to File Taxes for UTMA Accounts

If the child receives under $1,250 in unearned income — capital gains or investment income — in 2023, they don’t have to report anything.

However, if they earn more than $1,250 in 2023, a separate tax return must be filed on their behalf. 

Alternatively, the parent can include the child’s income on their return if all of the following conditions are met:

• The child is required to file (income exceeding $1,250)
• The child was under age 19 (24 if a full-time student) as of January 1, 2023
• The child's total income was under $12,500 and only interest and dividends (including capital gains distributions and Alaska Permanent Fund dividends). No earned income is included.
• The child is not filing a joint return
• No estimated tax payments were made for your child (including overpayments from the previous year applied to this year’s estimated tax)
• The child did not have any federal taxes withheld
• You're filing a joint return with your child's other parent, or you're the parent qualified to include your child's income on your return

Clarifying the UTMA Tax Rules

UTMA accounts offer parents a way to give their children a head start in life. But just because a child holds the account doesn’t mean they avoid taxes.

UTMA account holders may owe taxes at their personal rate and their parents’ rate if the account earns any investment income or capital gains on asset sales. 

By monitoring these earnings and keeping track of account gifts, parents and children can stay compliant with taxes while growing the UTMA balance.

If you want to learn more about the types of accounts you can use to kickstart your child’s finances, download the EarlyBird app today.

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