The Uniform Gifts to Minors Act (UGMA) allows a donor to contribute money or assets to a minor child without creating a legal trust. The law provides for the creation of an account, the proceeds of which exist for the benefit of the child and are taxed at their rate upon withdrawal. A custodian is usually established to manage the account with the fiduciary duty to do so in the best interest of the child. Upon reaching majority age, the account becomes the property of the child, who has discretion to use them as they wish.
The major advantage of a UGMA account is that it allows donors to make pre-tax contributions to a minor. The IRS allows the exemption of donations up to the annual gift tax exclusion cap, which was $13,000 in 2009, but otherwise there is no limit to how much cn be donated to a minor under UGMA. The donor pays no taxes on the contribution up to the IRS cap, and, even though the funds are taxed upon withdrawal, a net tax benefit accrues according to the difference in tax rate between the donor and the beneficiary. Furthermore, the IRS allows donations beyond the annual gift tax cap to be rated for as much as five years, meaning that a single one-time gift of as much as five times the annual cap can be exempted in parts over a five year period.
One drawback to the UGMA account is that it seriously affects the child’s ability to qualify for federal financial aid. The assets of the account are treated as property of the child, which is heavily weighted by federal aid guidelines. Nevertheless, if the parents of the child have considerable wealth and the child would be considered a dependent at the time they apply for aid, it’s quite likely they would qualify for litte or no aid anyway. The tax savings to the parent should be considered against the potential loss in federal financial aid if the child is planning on attending a postsecondary educational institution.
Details of UGMA accounts are determined by state law, which in some cases referred to as the Uniform Transfer to Minors Act, or UTMA. The age of majority varies according to state, affecting the age at which the beneficiary of the account can take possession of the assets. The federal “kiddie tax”, however, makes any withdrawals prior to the age of eighteen taxable at the parent’s tax rate, eliminating any potential benefit. Another consideration is that in some states death of a donor acting as custodian can subject the entire custodial property to the deceased’ estate tax liability.