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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?

Here your best option is to roll the UGMA/UTMA into a 529 plan and create a hybrid account known as an UGMA/UTMA 529, or custodial 529. As with any 529, assets in an UGMA/UTMA 529 grow tax-free, and the vehicle also allows for tax-free distributions to cover qualified college expenses. Your underlying investment choices are the same as with the noncustodial version of the 529 plan. However, not all 529 plans allow transfers from UGMA/UTMA accounts, so check to see if a transfer is even a possibility.

One important advantage that an UGMA/UTMA 529 offers versus a regular UGMA/UTMA is that it typically has a lower negative impact on financial-aid prospects as long as the student is still considered a dependent. If the UGMA/UTMA in question only has a few hundred dollars in it, such a rollover could be more trouble than it's worth. However, for a much larger sum, this financial-aid impact is worth taking into consideration.

Among the disadvantages of an UGMA/UTMA 529 account are that investment options are limited to the 529 plan's funds, whereas a regular UGMA/UTMA can be invested in whichever stocks, bonds, funds, or other assets the account owner chooses. For plans that do allow for UGMA/UTMA 529s, assets might be used only for college-related costs, and, unlike with regular 529s, assets in the account are not transferrable to other family members. It's also important to remember that, as with a regular UGMA/UTMA, control of a custodial 529 transfers to the minor once he or she reaches the age of majority. So if the student chooses not to go to college or to drop out, he or she can take the money and run, though the distribution might be subject to taxes and penalties.

One other important consideration when thinking about converting an UGMA/UTMA to a custodial 529 is that the former must be cashed out first, which could trigger capital gains taxes. (To help figure out if such a conversion makes sense for you, try this calculator from Vanguard.) Proceeds from the sale then must be used for the minor's benefit--in this case, to open an UGMA/UTMA 529. When you open the account, the 529 plan provider typically will ask whether the source of the funds is an UGMA/UTMA so that the account can be designated accordingly. This also provides you with a paper trail showing how funds cashed out of the regular UGMA/UTMA were used.

Given your limited options for transferring assets out of an UGMA/UTMA, you might also consider simply spending down the money in the account on qualified child-related expenses, such as summer camp or music lessons. You could then use the out-of-pocket money you would've spent on these expenses to establish a different type of account, be it a regular 529 or taxable account. If you're unsure what expenses might be paid from a custodial account, consult a tax professional.

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