What Is a UGMA Account? How Does It Work?

The Uniform Gift to Minors Act (UGMA) is a versatile tool that offers a unique way for parents, grandparents and guardians to invest on behalf of a child or grandchild.¹ But what is a UGMA account, how does it work and how does it compare to other college savings accounts?

This guide to UGMA accounts aims to shed light on their workings, advantages, considerations and the potential financial opportunities they present.

UGMA Account Defined

Established under the 1956 Uniform Gift to Minors Act, these accounts provide a legal framework for making financial gifts to minors. This custodial account allows individuals to transfer assets to a minor without the need to establish a trust. Commonly used for investments, they offer a straightforward mechanism for growing and managing assets for the benefit of a child.

How Does a UGMA Work?

Functioning as a custodial account, a UGMA account empowers parents, grandparents or guardians to transfer assets to a minor. The intent is to foster financial growth until the child gains control of the account upon reaching the age of majority. Understanding how these accounts work begins with understanding the account structure, permissible assets and age of majority.

Account Structure

A UGMA account is typically opened by a custodian, often a parent, grandparent or another relative. The custodian manages the account on behalf of the minor until they reach the age of majority, usually 18 or 21 depending on the state.

Permissible Assets

UGMA accounts can hold various types of assets, including cash, stocks, bonds, mutual funds and other securities. Real estate and other property may also be transferred to the account.

Tax Implications

While contributions to a UGMA account are made with after-tax dollars, the earnings generated within the account are subject to taxation. For 2024, the first $1,300 of the minor child's unearned income is tax-free. The next $1,300 is taxed at the child's tax rate. Amounts over $2,600 are taxed at the parent's tax rate.

Age of Majority

The key feature of a UGMA account is that it automatically transfers control to the minor when they reach the age of majority. At this point, the child gains full control over the assets. They can use them for any purpose, whether for education, a major purchase, a business opportunity or other financial needs.

Pros & Cons of UGMA Accounts

UGMA accounts offer multiple benefits, including tax efficiency and estate planning. Still, consider potential drawbacks — such as loss of control — before opening this unique type of minor account.

Pros of UGMA Accounts

• Tax efficiency: UGMA offers potential tax advantages. The first $1,300 of unearned income is tax-free and the next $1,300 is taxed at the child's rate.
• Flexible use of funds: Once the minor reaches age 18 or 21 (depending on the state), they gain full control over the assets. This flexibility allows the child to use the funds for any purpose without restrictions.
• Estate planning tool: UGMA accounts can be utilized as part of estate planning. They allow individuals to pass on assets to the next generation while maintaining control during their lifetime.
• Financial education: Managing a UGMA investment account can serve as a practical financial education tool for the child. They may learn about investing, budgeting and wealth management.

Cons of UGMA Accounts

• Loss of control: The custodian loses control of the assets in the UGMA investment account when the minor reaches the age of majority. At that point the child determines how to use the funds, without restrictions imposed by the custodian.
• Tax implications: While UGMA investment accounts offer tax advantages, the earnings generated within the account are subject to taxation. The "kiddie tax" may apply, potentially subjecting the child's unearned income to taxation at the higher rate of the parents.
• Financial aid impact: Assets held in a UGMA account can impact a child's eligibility for financial aid when pursuing higher education. The value of the account is considered in determining aid eligibility.
• Complexity of investments: Managing investments within a UGMA account requires careful consideration. Complex investments may not align with the simplicity often associated with custodial accounts. The custodian must be depended upon to make decisions in the best interest of the minor.

UGMA vs. Other College Savings Plans

While a UGMA account offers multiple benefits for individuals wanting to invest on behalf of their minor children or grandchildren, there are other college savings plans to consider. They include a Uniform Transfers to Minors Act (UTMA) account, a 529 Savings Plan and a Coverdell Education Savings Account.²

Here's how UGMA investment accounts compare to other college savings plans:

UGMA vs. UTMA

UGMA and UTMA accounts are similar in many respects. Both serve as custodial accounts designed for the financial benefit of minors. However, consider key differences when choosing between them:

Permitted Assets

• UGMA: Only financial assets, such as cash, stocks, bonds and mutual funds, are allowed.
• UTMA: A broader range of assets, including real estate, artwork and other tangible property, are allowed.

State Availability

• UGMA: Available in all 50 states and the District of Columbia.
• UTMA: Not available in Vermont and South Carolina.

Investment Flexibility

• Both: A custodian, typically a parent or another adult, manages the investments until the child reaches adulthood. However, some flexibility may exist depending on the state and custodian guidelines.

Taxes

• Both: Contributions are not tax-deductible for the donor. Earnings are taxed at the minor's rate, with the first $1,300 (in 2024) being tax-free. Distributions of principal are tax-free for the child. Earnings used for nonqualified purposes are taxed at the child's rate.

Other Differences

• UGMA: Simpler legal structure, easier to set up and manage.
• UTMA: Can be more complex due to potential property management considerations.

Choosing Between UGMA and UTMA

• If you primarily intend to invest in financial assets, either UGMA or UTMA will suffice.
• If you want the flexibility to hold real estate or other tangible property, then UTMA is the only option.
• Consider state availability if you anticipate moving or have beneficiaries in multiple states.
• Seek professional advice for legal and tax implications regarding specific asset types or complex situations.

Ultimately, the better choice depends on your individual circumstances and desired asset type flexibility. Both UGMA and UTMA offer valuable avenues for saving and investing for a child's future.

UGMA vs. 529 Savings Plan

Choosing between a UGMA and a 529 savings plan for a child's future hinges on your specific goals and priorities. Here's a breakdown of some key differences:

Purpose

• UGMA: Primarily used for general investment and wealth transfer, offering flexibility in fund use by the beneficiary upon reaching adulthood.
• 529: Specifically designed for qualified education expenses with potentially significant tax benefits and financial aid implications.

Contributions

• UGMA: No tax deduction for the contributor, limited to $17,000 per year per recipient without affecting gift tax exemptions.
• 529: Some states offer state income tax deductions for contributions, potentially reducing the tax burden. Annual contribution limits vary by state plan.

Earnings

• UGMA: Earnings are taxed at the child's rate, with the first $1,300 (in 2024) being tax-free. However, earnings used for nonqualified purposes will be taxed at the child's rate.
• 529: Earnings grow tax-free when used for qualified education expenses, such as tuition, fees, books, and room and board.

Distributions

• UGMA: Principal and earnings (which are taxed according to use) become accessible to the child upon reaching adulthood, offering unrestricted use but potentially impacting need-based financial aid eligibility.
• 529: Distributions for qualified education expenses are tax-free. Nonqualified withdrawals are subject to taxes and penalties.

Other Differences

• Investment choices: UGMA accounts offer wider investment options, while 529 plans typically focus on specified investments, such as mutual funds.
• Financial aid: UGMA assets can negatively impact need-based financial aid for college, while 529 plans are treated more favorably.
• Control: You maintain control of the UGMA account until the child reaches adulthood, while 529 plans eventually transfer ownership to the beneficiary.

Choosing the Better Option

• UGMA: Choose a UGMA investment account if your primary goal is flexible wealth transfer and investment for the child's future, not necessarily just education-focused.
• 529: Choose a 529 plan if education is your top priority, and you're seeking tax-advantaged growth and potential financial aid advantages. Consider state tax benefits and investment options offered by different plans, too.

Ultimately, the better option depends on your individual circumstances and priorities. Consult a financial professional for personalized guidance to help navigate the intricacies of the different account options, ensuring you make the most informed decision for your child's future.

UGMA vs. Coverdell ESA

Both UGMA and Coverdell Education Savings Accounts (ESAs) offer ways to save and invest for a child's future. But they cater to different needs and come with distinct regulations. Here's a quick comparison:

Purpose

• UGMA: Primarily used for general investment and wealth transfer, offering flexibility in fund use by the beneficiary on reaching adulthood.
• Coverdell ESA: Specifically designed for education expenses with tax benefits for qualified withdrawals but stricter limitations on spending.

Contributions

• UGMA: No contribution limit per se, but limited to $18,000 (in 2024) annually per recipient without affecting gift tax exemption. No tax deduction for contributions.
• Coverdell ESA: Annual limit is $2,000 per beneficiary, with phase-outs based on income. No tax deduction for contributions.

Earnings

• UGMA: Earnings are taxed at the child's rate, which is potentially advantageous with the first $1,300 (in 2024) being tax-free. However, earnings used for nonqualified purposes will be taxed at the child's rate.
• Coverdell ESA: Earnings grow tax-free when used for qualified education expenses, such as tuition, fees, books, and room and board. However, contributions must be made before the beneficiary turns 18 for potential tax-free growth.

Distributions

• UGMA: Principal and earnings (which are taxed according to use) become accessible to the child upon reaching adulthood. This offers unrestricted use but potentially impacts need-based financial aid eligibility.
• Coverdell ESA: Distributions for qualified education expenses are tax-free. Nonqualified withdrawals are subject to taxes and penalties. Unused funds remaining upon reaching age 30 must be distributed and are potentially subject to taxes and penalties.

Other Differences

• Investment choices: UGMA accounts offer wider investment options, while Coverdell ESAs have limitations to align with education expenses.
• Financial aid: UGMA assets can negatively impact need-based financial aid for college, while Coverdell ESAs are treated slightly more favorably.
• Control: You maintain control of the UGMA account until the child reaches adulthood, while Coverdell ESA ownership ultimately transfers to the beneficiary at age 18.

Choosing the Better Option

• UGMA: You may want to choose UGMA if your primary goal is flexible wealth transfer and investment for the child's future, not necessarily just education-focused.
• Coverdell ESA: You may want to choose a Coverdell ESA if you prioritize tax-advantaged education savings with specific limitations on spending, especially if the beneficiary is younger than 18.

Remember, both options have distinct advantages and disadvantages depending on your priorities and the child's age. Consider consulting a financial professional to help navigate the intricacies of each option and make the most informed decision for your child's future.

When to Use UGMA for Your Child

Using a UGMA investment account for a child involves careful planning, consideration of financial goals and awareness of the unique features of the account. Successful use of a UGMA account can provide valuable financial support for a child's education, major life milestones or the pursuit of entrepreneurial endeavors. As with any investment, individual circumstances vary. It's crucial to tailor the approach to specific goals and needs.

Here's what to know about using a UGMA account for your child:

Setting Up the Account

Consider opening a UGMA account early to maximize the potential for long-term growth. Define the financial goals for the child, whether it's education expenses, a major purchase or a financial head-start. The custodian is typically a parent, grandparent or legal guardian and manages the account until the child reaches the age of majority.

When selecting investments for your UGMA, choose a diversified investment strategy based on the child's time horizon and risk tolerance. Consider a balance of investments according to your objectives for growth potential with principal preservation.

Accessing & Using the Funds

Remember that control of the UGMA account transfers to the child when they reach the age of majority (18 or 21, depending on the state). Consider using this transition as an opportunity to educate the child about financial management.

Funds can be withdrawn for the benefit of the child and must be expenses not considered part of parental obligations. For example, since parents are obligated to provide basic living expenses for their children, you cannot withdraw UGMA money for food, housing and clothing.

Examples of Successful Uses

UGMA funds can be used to cover college tuition and related expenses, providing financial support for higher education. Funds can also support education and training beyond traditional college settings.

Beyond education, if the child shows an entrepreneurial spirit, UGMA funds could be used to support the start-up of a small business. UGMA funds can also be used in helping establish an emergency fund, teaching the importance of financial preparedness and building a strong foundation to begin adult life. The offshoot may be enabling the child to better plan and save and make major purchases, such as a first home.

Is UGMA Right for You?

UGMA accounts offer a dynamic avenue for nurturing the financial well-being of the next generation. While they come with considerations and potential drawbacks, their tax advantages, flexibility and educational benefits make them a compelling choice for those looking to provide a financial head-start for children or grandchildren. As with any investment strategy, careful planning, periodic review and adaptability are key to unlocking the full potential of UGMA accounts and fostering a legacy of financial empowerment.

In summary, UGMA accounts offer a valuable tool for financial planning, providing flexibility and potential tax advantages. However, the loss of control, tax implications, impact on financial aid eligibility and the potential complexity of investments are important considerations when exploring this custodial account option. It's crucial to carefully weigh these pros and cons based on individual financial goals and circumstances.

Consulting with a financial professional can help provide personalized guidance. Essential considerations include complying with tax laws, optimizing financial strategies and navigating the complexities associated with transferring control and managing funds for the minor.

Sources

1. SI SF01120.205 Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA) – Age of Majority (TN 1 - 02/2008). https://secure.ssa.gov/poms.nsf/lnx/0501120205SF.
2. Topic no. 310, Coverdell education savings accounts. https://www.irs.gov/taxtopics/tc310.
3. Fabric by Gerber Life. UGMA investment accounts for kids. https://meetfabric.com/ugma-investment-account-for-kids.