Image source: Getty Images.
Continue Reading Below
Children aren't legally allowed in most states to own financial assets, so parents who want their children to save and invest typically open custodial accounts. One common form of custodial account is known by the acronym UTMA. UTMA stands for the Uniform Transfers to Minors Act, which is the legal provision in many states that authorizes a custodian to hold assets on behalf of a minor child until the child reaches the age of majority -- typically either 18 or 21. Although the custodian has legal possession of the minor's assets in a UTMA account, UTMA also imposes a fiduciary duty on the custodian to hold the assets on the minor's behalf. In addition, for tax purposes, the account is treated as the minor's, rather than as the custodian's, which has its advantages.
Using UTMA accounts to invest for minor children
When you open a UTMA account, the ownership of the account reflects the fact that you're holding the assets as custodian for the minor child. An example of how a UTMA account would typically be registered is "Jane Doe, custodian for benefit of John Doe, UTMA." The name of the state whose specific UTMA laws are used is also typically included in the account title.
Once you've established the UTMA account as the custodian, you have broad powers to manage the assets on behalf of the minor child. You can make investments, buy and sell securities, and transfer assets across different UTMA accounts as you deem prudent for the child's best interest.
UTMA and tax
For tax purposes, the UTMA account is treated as belonging to the minor child. Although the parent is the custodian, the account bears the Social Security number of the child.
That can be advantageous if the child's tax rate is lower than the parent's tax rate, leading to lower overall tax liability. However, IRS provisions limit the use of UTMA as a means of obtaining favorable tax rates.
Spending UTMA assets
Where UTMA custodians sometimes get into trouble is when they spend money from UTMA accounts. The custodian isn't allowed to commingle UTMA money with their own personal money. In addition, UTMA money can't be used to satisfy legal obligations of the minor child's parent. That's especially important when the custodian is also the parent, because it's critical to separate legal obligations from supplemental support. For example, items like food and shelter are legal requirements that parents must provide for children, and a parent therefore shouldn't tap UTMA accounts to pay for those items.
That doesn't mean parents can't use UTMA money for anything. In general, custodians have broad discretion to spend on the child's behalf. Items like paying for a vehicle, camp fees, or tuition costs for private school fall under permissible expenditures. It's generally smart to use UTMA money as a supplement to the parent's own contribution toward a minor child's expenses, because the parent can then document that the UTMA account isn't the sole source of support.
UTMA accounts can be extremely useful as a way to hold, manage, and invest a child's assets. Just be aware of the limitations of a UTMA arrangement before you open a custodial account, or else you might end up making a financial move you'll later regret.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us firstname.lastname@example.org. Thanks -- and Fool on!
The article What Is UTMA? originally appeared on Fool.com.
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
Copyright 1995 - 2016 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.