We recently covered opening a custodial IRA for a minor. I’m a big fan of the Roth variety when it comes to custodial IRAs – gifts or contributions are post-tax anyways, and it eliminates tax confusion around deducting for Traditional IRAs. Plus – it leaves the minor with more money later on, and with significant time for compound interest to accrue.
That post prompted a great question from a reader:
Can you open a custodial account for a standard investment account? What if I don’t want to save for the child’s retirement? Maybe I will want to help them save for their education, start a business, or buy their first car, instead.
Great question.
We’ve discussed why a 529 plan and Coverdell ESA make sense for saving for education. But what about investing for purposes other than retirement or education? Where should you put money gifted to your children or saved for them on your behalf?
Why a Roth IRA Might Not Always Make the Most Sense for a Custodial Account
Don’t forget, any contributions to a Roth IRA can be withdrawn at any point, tax free. You’ve already paid taxes on those contributions. Earnings, however, are a different story. Outside of death, disability, reaching the age 59.5, or first-time home ownership, IRA earnings withdrawals will result in taxation (although the additional 10%penalty is waived for qualified educational expenses).
So why not just open a custodial Roth IRA, and encourage the minor to withdraw contributions, if needed, tax-free?
That’s a fair question. My response to that would be that just as you would create a custodial IRA to teach good life-long financial habits, you probably would not want to encourage poor life-long financial habits, like pulling money out of a retirement account.
A second, non-philosophical reason would be that IRAs have a maximum contribution limit of $6,500 for 2023 and $7,000 for 2024. This might be prohibitive for a minor that receives a large gift from a wealthy relative and/or earns enough income to far exceed that contribution limit. Who knows, maybe they even become the next Macaulay Culkin or Full House twin.
What then?
UGMA/UTMA Accounts
Just like with custodial IRAs, you can open a non-retirement custodial account for a minor.
They are referred to as a UGMA/UTMA account, and you can open one at just about any online broker.
UGMA and UTMA stand for the Uniform Gifts to Minors Act and Uniform Transfers to Minors Act, respectively. Fancy sounding, no doubt.
They were created to allow transfers/gifts to minors without the need for fancy trusts and fancy lawyers to set them up.
What’s the difference between the two? UGMA law limits gifts & transfers to bank deposits, securities (including mutual funds, stocks, and bonds), and insurance policies. UTMA law allows virtually any kind of asset (including all those under UGMA), including real estate, to be transferred to a minor. UTMA is an extension to UGMA. Almost all states have moved over to UTMA law.
Here’s how they work…
Who Opens, Controls, & Manages a UGMA/UTMA?
The custodian opens, controls, and manages the account until the minor reaches age of majority (varies by state) – just as with a custodial IRA.
At age of majority, the beneficiary can use the assets for any purpose.
What Can you Invest in?
Anything you would normally be able to invest in normally with that broker. Usually minimum typically apply.
UGMA/UTMA Contributions
Contributions can be made by the minor or anyone else. Contributions are not tax-deductible, however, you can give up to $17,000 (2023) or $18,000 (2024) per year ($34,000 in 2023 or $36,000 in 2024 for a married filing jointly couple) to an individual without incurring federal gift tax. This is referred to as the “federal gift tax exclusion”.
Contributions are irrevocable as well. Meaning, once you transfer to the minor’s account, you can’t get it back.
UGMA/UTMA Tax Considerations (the “Kiddie Tax”)
Earnings are subject to federal income or capital gains tax. Some of the potential tax advantages have been limited by rule changes in recent years that have increased the age limit for applying a child’s tax rate to investment income.
Check out this IRS publication on the “Kiddie Tax” on a minor’s investment income. Basically, the first $1,250 (2023) or $1,300 (2024) of a child’s interest, dividends, and other unearned investment income is tax free. The next $1,250 or $1,300 is subject to the child’s tax rate. Any additional earnings above $2,500 (2023) or $2,600 (2024) are taxed at the child’s parents’ marginal tax rate. In other words, you can’t use your child’s UGMA/UTMA as a tax safe haven.
Financial Aid Implications
UGMA or UTMA account may affect the amount of financial aid your child is eligible for. Parental income is less heavily weighed than a child’s income. Some parents invest in their own name instead of in a UGMA/UTMA because of this.
UGMA/UTMA Discussion:
Have you set up one of these accounts for a minor? Under what circumstances?
How long can you leave money in your UGMA/UTMA account once you the minor has now reached age of majority and have full ownership? I heard that I could leave my money in the UGMA/UTMA but once I hit age 30 then I could be penalized/taxed if left in there. And it was recommended to move the money into another type of retirement account or tax deferred account since I was not going to be using the money anytime soon.