UTMA Custodial Accounts: Benefits and Drawbacks for Your Child’s Future

Starting an investment account for your child, such as a UTMA, can set them on a path to long-term financial success.

Many parents and grandparents want to give children a financial head start. One popular tool for this is a UTMA account, which stands for Uniform Transfers to Minors Act account. UTMAs are a type of custodial account that allow an adult to hold and invest assets for a child until they come of age. These accounts offer a number of benefits that can help pave the way for your child’s future – but they also come with some important drawbacks/considerations to be aware of. In this article, we’ll explain the key advantages of UTMAs and the potential disadvantages, so you can decide if opening a UTMA for your child is a smart move.

What is a UTMA?

A UTMA (Uniform Transfers to Minors Act) account is a custodial investment account that allows a parent, guardian, or other adult to transfer assets to a minor child. The account is opened in the child’s name, but managed by the adult custodian until the child reaches adulthood (the age of majority, which is typically 21 in many states for UTMAs, though it can vary by state – some states allow extending to 25). Almost any asset can be contributed to a UTMA: cash, stocks, bonds, mutual funds, and even real estate or art in some cases. The key point is that these contributions are considered an irrevocable gift to the minor – once you put money or assets into a UTMA, you legally cannot take it back and the assets now belong to the child. The custodian must invest and use the assets for the benefit of the child until they come of age. When the child reaches the specified age, they gain full control of the account and can use the funds for any purpose.

Many families use UTMAs to save for a child’s college tuition, first car, down payment on a house, or simply to give them a nest egg to start adult life. Unlike 529 college savings plans, which are restricted to education expenses, UTMA funds have no usage restrictions – the beneficiary (child) can use the money for anything once they’re an adult. This flexibility is one of the big advantages, but as we’ll see, it can also be a drawback if the child isn’t prepared for the responsibility.

Tax Treatment: UTMAs are taxable investment accounts (not tax-deferred like a 529). However, they do offer some tax advantages for unearned income (earnings from the investments). The first portion of the child’s annual investment income is tax-free, and the next portion is taxed at the child’s low tax rate. Only unearned income above a certain threshold is taxed at the parent’s tax rate (this is known as the “kiddie tax”). For example, in 2024 the first $1,300 of a child’s unearned income is tax-exempt, the next $1,300 is taxed at the child’s rate, and any unearned income over $2,600 in a year is taxed at the parents’ rate. This means moderate investment growth in a UTMA can be very tax-efficient compared to if the assets were held in the parent’s name.

Key Benefits of UTMA Accounts

1. Tax Advantages on Investment Earnings: As mentioned, UTMAs allow a child to take advantage of their lower tax bracket on investment income. A child can have a certain amount of interest, dividends, or capital gains each year at little to no tax. For instance, if the account earns $1,000 in dividends, that may fall under the tax-free threshold for the child, whereas if the parent held those assets, that $1,000 would be taxed at the parent’s higher rate. This can help the account grow faster since less money is lost to taxes along the way. (Note: very large investment earnings will invoke the kiddie tax, so extremely wealthy families might use trusts or other vehicles beyond UTMAs to manage taxes.) Over many years, these tax savings can meaningfully boost the child’s asset accumulation.

2. Flexibility in How Funds Can Be Used: Unlike certain accounts earmarked for specific goals (e.g., 529 college plans can only be used for qualified education expenses without penalty), UTMA funds are not limited to education or any particular purpose. When the child reaches adulthood, they are free to use the money for anything – college tuition, trade school, starting a business, buying a first home, wedding expenses, or even travel or personal needs. There are no penalties or extra taxes for using UTMA money on non-education expenses. This flexibility is great because every child’s path is different – if your child doesn’t go to college, the UTMA money can help them in other ways. Essentially, you’re providing a financial springboard that they can apply to their adult life wherever they see the greatest need or opportunity.

2. A Chance to Teach Financial Responsibility: Opening an investment account for a child creates a fantastic hands-on opportunity to teach them about money. While the child is young, the custodian manages the UTMA. But you can periodically show the child the account statements, explain how contributions and investments work, and even involve them in choosing investments as they become teenagers. Seeing their money grow can be highly educational. By the time they assume control at 18 or 21, they ideally understand the value of the account and basic financial concepts like saving, investing, and compound interest. This early financial education can set them up to be more responsible with the money when it’s theirs. Many parents find that involving the child in managing their UTMA helps instill good money habits and confidence in handling finances. It can be far more impactful than just a theoretical allowance or piggy bank lesson.

3. Easy and Low-Cost to Set Up: UTMAs are relatively simple to open at most financial institutions – similar to opening a regular brokerage account, but titled under a custodial arrangement. There are usually no special fees or complex legal work needed (unlike setting up a trust which can be costly). This makes UTMAs an accessible option for the average family. You can start with modest contributions (even $100 to open and small monthly deposits). Over time, those contributions and invested earnings can compound significantly by the time the child is an adult. (Tip: Use our calculator to estimate how much your child’s UTMA could grow over time, given a certain monthly contribution and rate of return.) Also, any family member or friend can contribute to the UTMA – for example, grandparents could gift money into the account for birthdays or holidays, helping it grow even faster.

Did You Know? An investment of just $1,000 at the time of your child’s birth could grow to more than $128,000 by the time they are 25, assuming a 10% annual return and an additional $100 contributed monthly. That’s the power of starting early and compounding growth! Even small, regular contributions to a UTMA can potentially turn into a significant financial asset for your child’s young adulthood.

Potential Drawbacks and Considerations (UTMA)

While UTMAs offer great benefits, it’s important to go in with eyes open about a few disadvantages and risks:

• Child Gains Control at Maturity: Perhaps the biggest concern for many parents is that once the child reaches the age of majority (typically 21 for UTMAs), the money is legally theirs – the custodian must hand over control. The now-young-adult can use the funds however they wish, and you as the parent no longer have a say. If the child has not developed responsibility or if they face peer pressure, there’s a risk they could squander the money on things you might not approve of. For example, imagine an 21-year-old suddenly having access to a sizable account – will they use it wisely (college, home, business) or blow it on a sports car or a lavish trip? This “control” issue is a trade-off: the same flexibility that is a benefit can backfire if the child isn’t ready. You know your child best; consider how to prepare them. Some states allow delaying the transfer beyond 21 (to 25) if you specify when setting up the account, which might be worth exploring. Ultimately, though, once they’re of age, it’s their asset. This is in contrast to setting up a trust, where you could impose usage conditions beyond 21 (but trusts are more complex). Many families decide the trust route isn’t worth it for moderate sums, and instead focus on educating the child to handle the UTMA responsibly.

• Impact on College Financial Aid: Assets in a UTMA are considered the student’s asset when filing for financial aid (FAFSA). This is disadvantageous compared to money in a parent’s name or in a 529 plan. Student assets count more heavily in financial aid formulas – generally, about 20% of a student’s assets are expected to be used for college each year, whereas parent assets are assessed at a max of 5.6%. In practical terms, having money in a UTMA could reduce the amount of need-based aid or scholarships your child qualifies for. For example, $10,000 in a UTMA could reduce aid by up to $2,000, while that same amount in a parent’s account might only reduce aid by a few hundred. If you are aiming for financial aid, this is a consideration. Some families choose to spend down or roll UTMA funds into a 529 plan before college to minimize the impact (though once in a 529 owned by a parent, those funds are a parent asset – better for aid). It’s a bit of a balancing act: the UTMA can help save for college, but it might count against need-based aid. Planning ahead with a financial advisor can help manage this issue.

• Taxes on Large Unearned Income (Kiddie Tax): While UTMA tax treatment is favorable for moderate investment earnings, if the account becomes very large or generates significant income (interest/dividends), the kiddie tax rules will tax the excess at the parents’ rate. This essentially caps how much unearned income can be taxed at the child’s low rate. In 2024, any unearned income over $2,600 in the year is taxed at the parent’s rate. This typically isn’t a problem unless the account holds substantial assets (or assets that throw off big taxable distributions). For example, if a UTMA contained high-yield bonds throwing off $5,000 interest annually, a good chunk of that would be taxed as if it were the parent’s income. One way to manage this is by choosing more growth-oriented investments (stocks or funds that mainly appreciate rather than pay large dividends) to defer taxation. Also, remember that any realized capital gains if you sell investments in the UTMA are part of unearned income too. The bottom line: for most typical-sized accounts the tax advantages hold, but very large accounts may lose some tax benefit. Nonetheless, even with kiddie tax, the child still got tax-free treatment on the first portion, so it’s not worse than if assets were in the parent’s name – just something to be aware of.

• Irrevocable Gift – No Take Backs: Once you contribute money or property into a UTMA, it’s legally the child’s asset, not yours. The custodian can only use those funds for the benefit of the child. You cannot later decide “I need that money back for myself” or use it for another child (each UTMA is for one beneficiary only). So you should be confident that any funds you put in are truly set aside for your child. If your financial situation changes (say you face an emergency or job loss), you can’t dip into the UTMA for your own needs. Some parents choose to contribute smaller amounts to the UTMA and keep the bulk of college savings in their own accounts or a 529, just to retain flexibility. It’s all about balance – don’t over-contribute to a UTMA if it might jeopardize your own finances. Also, because it’s irrevocable, if the child tragically passes away before adulthood, the UTMA assets would go to their estate or as directed by state law, which may result in those assets going somewhere you didn’t intend. This situation is rare, but it underscores that once gifted, the assets are out of your control.

In summary, the disadvantages mainly revolve around control and flexibility – you lose control eventually, and the assets’ presence can affect things like financial aid. There are also some tax limitations for very large accounts. Despite these considerations, many find the benefits outweigh the drawbacks, especially if the amounts are reasonable and the child is being guided to handle money wisely.

Recommendation: If you decide to set up a UTMA for your child, also create a plan to educate them over the years about the account. Transparency and guidance are key. For example, when your child hits their mid-teens, start having regular finance talks: review the UTMA statement together, discuss how investments work, maybe even let them help pick a mutual fund or stock for the account to spark their interest. Emphasize the purpose of the funds (college, etc.) so they mentally earmark it for that. By the time they take control, they’ll (hopefully) respect the gift and use it prudently. Additionally, consider combining a UTMA with other strategies: e.g., use a 529 plan for college (for tax-free education savings) and a UTMA for more general or supplemental savings. And always ensure your own retirement needs are on track before funneling large sums into a child’s account – remember, there are no loans for retirement, but there are loans and aid for college. A financial advisor at Green Musa Capital can help you find the right balance. UTMAs can be a fantastic tool to build wealth for your child, as long as you go in with a solid game plan.

Quick Resources for Further Reading:

- IRS: Tax Rules for Children with Investment Income (Kiddie Tax)

- Investopedia: UTMA and UGMA Accounts