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Gifting to Minors with Custodial Accounts
Legally speaking, a minor is a person under the “age of majority,” which defines the transition from childhood to adulthood. The age of majority depends upon the jurisdiction and application, but it commonly occurs at age 18 in most states.
While minors cannot legally own assets outright, you can transfer assets to your minor child or any minor children, regardless of whether they are related to you. However, you must adhere to specific rules to ensure these transfers are legal and tax efficient. There are several options for gifting to minors, depending on your situation and goals. This article will introduce one of these methods: the custodial account.
UGMA and UTMA
Have you heard of the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA)? Parents often set up custodial accounts, as either UGMA or UTMA accounts, to make gifts to their minor children, usually for college education. These accounts are popular and are a simpler, less expensive alternative to creating and administering a formal trust for the minor child.
You are making an irrevocable gift to a minor child with either account, and the account is held under the child’s Social Security number. As a result, any taxes on the bill are reported on the child’s income tax return. These two accounts also have subtle but significant differences.
For example, UTMA accounts can hold a wider variety of assets for longer than UGMA accounts. Whereas UGMA account investment options are limited to traditional financial products, like savings accounts, certificates of deposit, stocks, and bonds, the UTMA account investment options are much broader, extending to nearly any manner of tangible or intangible asset. Limitations are typically in place to prevent the custodian from higher-risk investing, like buying securities on margin.
The accounts also differ regarding how long they can be withheld from the minor child’s direct control after attaining the majority age under state law. UGMA accounts become fully available at age 18, while UTMA accounts can be withheld until age 21. This delayed availability age under a UTMA account can prove invaluable, especially if the newly-minted young adult is financially immature. Consequently, funds held in a UTMA account are more likely to be used for college when controlled by a parent until the child is age 21.
Older age controls are available in other trusts, which an estate planning attorney can help you create.
How They Work
While underage, the beneficiary cannot serve as the custodian of a UGMA or UTMA account. Consequently, an adult or financial institution will act as the account’s custodian. The parent who contributes the funds into the account usually also serves as its custodian. Once the account is opened, any friend or family member can make deposits into the account for the child. At that point, assets in the account belong to the child beneficiary. If the beneficiary applies for federal financial aid for college, the account will be considered an asset of the
beneficiary when determining student loan eligibility.
Tax-Free Gifting Rules
The law limits how much can be added to either of these accounts per year without triggering gift taxes. Under current law, the “annual gift exclusion” amount is $16,000 per donee (to increase to $17,000 on January 1, 2023). In other words, you and your spouse could each deposit $15,000 into your son’s UTMA account each year without triggering gift taxes. By not exceeding this $16,000 limit, no Form 709 Gift Tax filing is required. “Gifts” include all gifts made during the year, even birthday gifts. Your gifts to your son are not considered “income” reportable on his tax return, but they are not “deductible” on your tax return.
What if you want to gift more than the annual exclusion amount in a given year? What if you want to leverage a “down market” and transfer currently undervalued assets to take advantage of potential exponential appreciation later? In 2020, the maximum transfer you and your spouse may make to your son without triggering gift taxes is $23,190,000! You would need to file a Form 709 Gift Tax Return to report the value of your gift in 2022 when filing your personal income tax return. Giving more than $20 million to any newly minted adult may not be a wise move. Therefore, a custodial account may not be the best option if you are considering a substantial gift to a minor child.
Trust a Trust?
Therefore, what is an alternative to a custodial account when making a substantial gift (or series of gifts) to a minor child over the annual gift exclusion? As a famed jurist, Oliver Wendell Holmes Sr., famously quipped, “Put not your trust in money, but put your money in trust.” Consequently, consider creating an irrevocable trust with your minor child as the beneficiary. This approach provides many benefits not available with a UGMA or UTMA account. For example, a trust can be designed to protect the inheritance from and for your son.
An irrevocable trust can shield gifted assets from being squandered or lost to potential divorces, lawsuits, or bankruptcies. There are very few negatives to using an irrevocable trust when making substantial gifts to loved ones. Creating, funding, and administering an irrevocable trust is not a do-it-yourself project. Work with an experienced estate planning attorney when considering your gifting alternatives.
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