Should I open an investment account for my kids?
The answer, as with most financial decisions, is “it depends.” There are many factors that may contribute to the decision of whether opening an investment account for your child may be right for you.
What is an UTMA?
A type of brokerage account that is opened by an adult (usually either a parent or grandparent) for the benefit of a minor. The purpose of an UTMA is to allow parents or any other gift giver to transfer money to a child and either invest it for them or spend it for the child’s benefit. UTMA stands for “Uniform Transfers to Minors Act”. It is called a “custodial” account because the account opener (the “custodian”) only manages the account until the minor reaches legal adulthood – typically either 18 or 21. Depending on the state, the transfer of the account to the child may be delayed until the child is 25.
What are the advantages of opening an UTMA custodial account?
There are tax benefits to using an UTMA. Specifically, an UTMA can shield some investment income, such as dividends, interest, and capital gains, from being taxed. Current law allows up to $1,100 of investment income tax-free. Then, the next $1,100 of investment income is taxed at the child’s federal tax rate, which typically is much lower than the parent’s.
Using an UTMA can also be a cheap alternative to a trust. Trusts are typically expensive to set up and maintain, whereas UTMAs can be opened online in a matter of minutes and require very little overhead.
The UTMA account is also a tool that provides flexibility in the functions it can provide. The account may buy any investments that the custodian deems beneficial to the child. The funds may also be liquidated at any point to pay for expenses that benefit the child or, once the child reaches the age specified by the account, spent by the child on anything they would like. This is in contrast to a 529 account where the funds have limited investment options and may only be used for qualified expenses pertaining to education.
How much can I deposit into an UTMA each year?
The contributions to the account are subject to gift tax limits, which is set at $15,000 for 2021. This means that a married couple could contribute up to $30,000 with no gift tax implications. The gift tax limitation is applied on a per person basis, not per account.
Are there any disadvantages to opening an UTMA for my kids?
Yes. If your child is going to apply for financial aid for college, assets in an UTMA will be counted against them. Currently the financial aid calculation includes 20% of the value of UTMA assets. For reference, the assets in a 529 account owned by the student’s parents are only counted at a 5.64% rate on the FAFSA. If you are planning on applying for student aid for your child, then an UTMA will lower the amount of aid that your child is eligible for.
Another important consideration is something called “kiddie tax”. As mentioned above, currently $2,200 of investment income from UTMAs are either not reported or taxed at lower rate. However, any income over $2,200 is taxed at the parents’ marginal tax rate. This means it is important to prudently manage the money in the account so neither you nor your child is hit with a surprise tax bill. Also, if the child chooses to liquidate the investments in the account, the transaction could trigger a capital gain that will create a tax liability.
A final consideration is that once the child reaches the age specified in the account, the entire account will be controlled by the child. The money may be used in any way they see fit because it belongs to them. The custodian of the account must weigh the decision of giving their child money with the risk that their child have the financial knowledge necessary to handle it.
Should I choose age 18 or 21 to transfer the UTMA?
Financially, there is no clear advantage in either decision. The income generated in the account is reported on the child’s tax return, regardless of the age of transfer.
Rather, the decision should be based on when you think your child will be prepared to inherit the money, since it will become their legal property at the age you choose. We typically recommend 21 so your child has the most time to gain the appropriate financial knowledge needed to handle their new account.
The decision of whether or not to open an UTMA for your child depends on your specific situation and the goals you are trying to achieve. If the goal is to save for college, then a 529 plan may be a more suitable choice for you. However, if your goal is to transfer wealth in a low-cost, efficient manner, then this may be the right option for you.
Please consult with a Taylor Hoffman investment advisor to see if an UTMA is right for you.
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