How to make gifts to your kids (with strings still attached!)

A common method of providing for education and long-term savings for children by parents is the creation of accounts under the “Uniform Gifts to Minors Act” (UGMA) or the more flexible “Uniform Transfers to Minors Act” (UTMA).  This month’s edition of the AICPA’s The Tax Adviser contains a good case study that sheds some light on the use of UGMAs and UTMAs.  You can read the article here.

These types of transfers are very simple to set up and, if the parents appoint themselves as custodians, allow the parents to continue to control the funds.  The accounts are governed by state law.  UGMA accounts prohibit many types of investments including real estate.  Many states have enacted the UTMA laws in order to allow for these other investments.

The income generated by the investments is taxed to the child.  However if the parent is the custodian on the account all of the transfers will be includable as part of the parents estate.  Gifts of up to $13,000 per year can be made by each parent (or anyone else for that matter) to each child with no gift tax consequence.

There are disadvantages that should be considered prior to establishing these types of accounts.  These considerations include:

1)      If the funds are used to pay for legal support obligations of the child the income generated will be reportable by the parents.  The legal support definition is determined on a state-by-state basis.

2)      When the child reaches the age of majority (anywhere from 18 to 21 again determined by state law) the funds must be distributed to the child.  These funds will then be controlled by the child.

3)      The money in these accounts may impact the child’s eligibility for college funding.

4)       The income generated by these funds will usually be taxed at the parent’s highest marginal rate (i.e. the “Kiddie Tax”).

Parents should be aware of these and other considerations prior to establishing UGMA or UTMA accounts.  Alternative funding such as college 529 plans may be more suitable in specific situations and may also be more tax efficient.