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George F. Bearup, J.D. Senior Legal Trust Advisor

21-Oct-19

Uniform Transfer to Minors Act Accounts – The ‘Kidde Tax’ and Source for College Education Expenses

Take-Away: The unearned income generated by a uniform transfer to minors act account (UTMA) will be taxed to the minor. However, after $2,100 in reported income, the balance of the UTMA’s income will be taxed at the  parents’ marginal income tax rate. A 529 account is a better tool to use to save for the minor’s college education.

Background: In most states, a donor can open a Uniform Transfer to Minors Act (UTMA) account. The UTMA replaced the former Uniform Gifts to Minors Act (UGMA). The main difference between the two is that with the UGMA the custodian can hold only securities. With the UTMA account, other assets besides securities can be held. For example, under Michigan’s version of the UTMA, the custodian can hold real estate, life insurance, powers of appointment, tangible personal property, and marketable securities. [MCL 554.533.]

UTMA Duration: Under Michigan’s version of the UTMA, the default rule is that once the child attains age 18 years, he/she has full access to the assets held in the UTMA. However, if at the time of transfer of assets to the UTMA account the transferor specifies that the asset will be held until the minor attains age 21 years, that restriction will control when the child will have access to the asset held in the UTMA. [MCL 554.547.] In California and Nevada, a UTMA account can delay the child’s access to the UTMA assets until age 25.

Taxation of UTMA Income: The taxation of income generated by the UTMA can be complicated due to the Kiddie Tax.

Kiddie Tax: A child who turns 20 (or 24) by the end of the tax year is not subject to the Kiddie Tax. [IRS Publication 929; Forms 8614 (Parent’s Election to Report Child’s Interest and Dividends) and 8615 (Tax for Children Who Have Unearned Income).] However, if the child beneficiary of the UTMA is under age 19, or under age 24 and a dependent full-time student who does not have any of their own earned income and their entire income is unearned income from investments, the taxation of the UTMA is as follows:

  • The first $1,050 of unearned income is tax-free (if this is the only income of a dependent child, then the child does not even need to file an income tax return);
  • The next $1,050 of unearned income is taxed at the child’s rate (10%, if the parent elects to include the child’s income on the parent’s own tax return, regardless of the composition of those earnings): and
  • Any income above that cumulative $2,100 of unearned income is taxed as if it had been recognized on the parent’s own income tax return. Consequently, the child’s income above  $2,100 will be taxed at the parent’s income tax rate, but which rate? Income or capital gains?
  • The way this calculation works is that the parent calculates how much income tax they would owe if the amount above $2,100 had been recognized on the parent’s own income tax return. Then the parent takes their actual income tax that is due (without consideration, or add-on, of the child’s excess unearned income.) The difference between those two amounts is the child’s income tax.
  • If the child is under age 24, is married, and files a joint return with their spouse then the Kiddie Tax will not apply.
  • In some cases, it may make sense for the child to file their own individual income tax return, not as a dependent of their parent, in order to take advantage of their own $12,000 standard deduction.
  • With a change under the 2017 Tax Act, any accumulated income held in an irrevocable trust for a minor will also be subject to the Kiddie Tax.

UTMA Used for Education: Currently UTMA assets will count as the student’s asset; those assets are weighted 20% in FAFSA eligibility calculations. Loosely translated, this means that the student will be required to draw down 20% of his/her UTMA assets each year to finance their own college education. In contrast, if the parent owns a 529 college education account for their child, the 529 account’s assets are weighted at 5.64% in FAFSA eligibility calculations.

Two Year Returns Reviewed: While the FAFSA application requires a student to state his/her net worth as of the date that application is submitted, if the UTMA account is emptied just prior to the student filing the FAFSA application, where it would show a $0.00 balance at the time of submission, a recent change to the FAFSA rules stopped this ‘gamesmanship.’ The FAFSA folks got wise to that trick, so they now require income tax returns from the prior two calendar years before the start of the school year when disclosing income amounts of the child-applicant. As such, any prior income generated from the UTMA account will now show up on the child’s tax returns submitted along with the FAFSA application.

UTMA and 529 Accounts: The primary benefit of a 529 account is that most distributions from that account, if used for higher education expenses, will be income tax-free. Consequently, a 529 account would best be used for tuition, room and board, fees, computers, software, Wi-Fi fees, all of which are directly related to the student’s higher education. While the concept of higher education expenses is broad, there are obvious limitations. It is when an expenditure is not clearly related to higher education that a UTMA account might better to be used for that expenditure. Examples of non-higher education expenses would be: the purchase of a car that the student drives while in school; the purchase of a home or condo in the university city that the child occupies while attending college; the airline fees that the child incurs if he/she is going to spend a year studying abroad; gym memberships; spending money; and possibly music lessons if that is not the student’s major focus of study. If 529 account assets are used for any of these non-higher education expenses, the distributions will be subject to income tax and an additional 10% tax since the funds were not used for higher educational expense purposes.

Conclusion: A UTMA account permits far more flexibility in its investments than a 529 account. Balanced against that investment flexibility, however, is the fact that UTMA income is taxable in contrast to a 529 account [or a Coverdell Education Savings Account] where the distributions are, like a Roth IRA, income tax-free. Using a UTMA account to hold long-term capital assets may make sense as capital gains rates are lower than ordinary income tax rates, but that just reduces and does not eliminate the income taxes that the UTMA beneficiary actually pays. Both a UTMA and a 529 account can co-exist for a student, but thought needs to be given to which expense should be paid from which account.