Under ordinary rules, minors can’t own investments like stocks, bonds, or mutual funds because they’re not allowed to sign contracts. The Uniform Gifts to Minors Act (UGMA) makes it so that minors can own these types of accounts without needing an attorney or a court order to create a trust. That way parents can gift assets to minor children.
The parent or other donor can create a custodial account for the minor child by appointing a custodian and then giving the name and social security number for the minor child. Only one minor child can be the beneficiary of a single UGMA trust. Only irrevocable gifts can be donated to the trust. Irrevocable gifts cannot be given back to the donor. They also cannot be changed to a different beneficiary. The gift avoids probate once the donor passes away since the minor child owns it. Once the gift has been made, the minor child is the owner, but the custodian controls it until the minor reaches age 18 or 21 depending on which state.
Funds in a UGMA trust can be invested just like funds in any other type of account. The custodian, who can be the parent or legal guardian or someone else, has the power to manage and invest the property just as they would do with their own property, but they’re required to make “prudent” decisions about the account. The custodian can withdraw money from the trust, even before the child reaches the age of majority, as long as it’s to make purchase for the benefit of the child, but not for something that’s considered a parental obligation, e.g. food, clothes, or shelter. Custodians typically need to keep record of all transactions made with the property and they’re required to keep a copy of tax returns associated with the account.
If the custodian passes away, then a new custodian must be named for the account. This is especially important if the parent was the original custodian and the minor child doesn’t want the new legal guardian to control the trust. Parents can often use their will to name a custodian to exceed them in their death. Sometimes the custodian names a successor when the account is set up, but if that doesn’t happen, the minor child may be able to name their own successor depending on state law.
Withdrawals from an account established under the UGMA are subject to tax based on the child’s tax rate. In addition, earnings are subject to Federal income and capital gains tax for the child, not for the custodian or the donor. Minors over age 14 are required to sign their own tax returns.
Once the child reaches the age of majority in their state, they have complete rights to the funds in the account. They can use the money in any way they wish since parents nor custodians are allowed to make restrictions on how the account can be used.
There may be other drawbacks to establishing a UGMA. For example, the child may not qualify for financial aid based on the amount of assets in the trust account, even if the child would qualify based on the parents’ financial status. On the other hand, parents might set up the UGMA trust to specifically save for the child’s college education. There are higher limits on gift deductions for donations to a UGMA trust and there’s no penalty on the account if the child doesn’t use the money to pay for college.
Before you set up a trust for your child, make sure your state has adopted the UGMA.