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Don't Let an UGMA Leave You Saying 'Ugh'

UGMA/UTMA accounts offer tax advantages, but beware of pitfalls. 

Morningstar, 02/21/2012

Question: I set up an UGMA for my daughter as a way to help save for college, but now I read that the money in the account could hurt her chances of getting financial aid. Can I cash out the account or move the money to a different type of college-savings plan?

Answer: You're asking the right questions, but you might not be all that satisfied with the answers.

Let's start by looking at what UGMA stands for, which is the Uniform Gifts to Minors Act. It and its sibling, the Uniform Transfers to Minors Act, or UTMA, allow for the establishment of custodial accounts, vehicles that allow minors to own securities (in the case of the UGMA) as well as other assets such as real estate (in the case of the UTMA). Rules for these account types vary from state to state.

The key to understanding the advantages and disadvantages of these account types are the words "gifts" and "transfers." By establishing an UGMA/UTMA for your child, you are handing over to him or her any assets you contribute to the account. Even though you retain control as the custodian, those assets may be used only for the child's benefit (that is, not to cover basic parental obligations such as food and shelter). Furthermore, when the minor in whose name the UGMA/UTMA account is established reaches age 18 or 21 (depending on the state and type of account), he or she assumes control of all the assets.

Because assets in the account are technically considered property of the child, this can create a tax advantage. Under current law, the first $950 of earnings on the account are tax-free, the next $950 are taxed at the child's rate, and earnings beyond that are taxed at the parents' rate. This helps save money for parents or grandparents who'd rather not pay additional income tax on a savings vehicle for their child or grandchild.

The downside (aside from the risk that your child may not use the money in the way you had intended) is that these assets, being the child's, may count against him or her in college financial aid calculations. This is in contrast with 529 savings plans, in which assets are owned by the account holder on behalf of a beneficiary, reducing the impact on financial aid eligibility.

Consider Custodial 529 Accounts
To address your situation, it's important to keep in mind that once money is gifted to a minor, it stays gifted. The custodian cannot simply cash out the account and pretend it never happened because; in the eyes of the government, this would constitute taking money that belongs to a minor. It's not exactly taking candy from a baby, but you get the point. Rather than allowing parents or others to raid a child's UGMA/UTMA account--or using one as a sneaky way to pay a lower tax rate on earnings while maintaining ownership--the government makes this transfer of assets irrevocable.

And what about moving the money into another type of tax-advantaged educational savings account?

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