Series 7

AAA

Retirement Accounts - Custodial Accounts

This all works well if the individuals who are receiving the gifts are adults, but what about young children? In most states, minors do not have the right to contract and thus cannot own securities. Parents cannot simply transfer assets to their minor children.

They can, however, transfer the assets to a trust. The most common trust for a minor is known as a custodial account, and there are two types:

  • The Uniform Gift to Minors Act (UGMA) established a simple way for a minor to own securities without requiring the services of an attorney to prepare trust documents or the court appointment of a trustee. The terms of this trust are established by a state statute instead of a trust document.
  • The Uniform Transfer to Minors Act (UTMA) is similar to the UGMA, but it also allows minors to own other types of property, such as real estate, fine art, patents and royalties, and for the transfers to occur through inheritance. UTMA is slightly more flexible than UGMA.

To establish a custodial account, the donor irrevocably gifts the assets to the trust. The money then belongs to the minor (the beneficial owner), but is controlled by the custodian (the nominal owner) until the minor reaches the age of trust termination, when he or she attains the age of majority, which is 18 for most UGMAs and 21 for most UTMAs. The age of majority varies by state. The custodian has the fiduciary responsibility to manage the money in a prudent fashion for the benefit of the minor. Custodial accounts are most often established at banks and brokerages. Any money in custodial accounts for which your client is the custodian will be counted as part of his or her taxable estate.

Other Custodial Account Considerations

  • Reporting Income: The income from the custodial account must be reported on the child's tax return and is taxed at the child's rate.
    • The parent is responsible for filing an income tax return on behalf of the child.
    • There is no special tax treatment for UGMA or UTMA accounts.
    • Children aged 14 and older must sign their own tax returns.
  • Naming the Account: It is important to name this account correctly. The proper way to title a custodial account is "[Custodian's Name] as custodian for [Minor's Name] under the [Name of Minor's State of Residence] Uniform Gift to Minors Act".
    • An "In Trust For" account is something different.
    • If you intend to establish a UTMA account instead of a UGMA account, substitute the word "Transfer" for the word "Gift".
  • Restrictions on the Use of Funds:
    • Neither the donor nor the custodian can place any restrictions on the use of the money when the minor becomes an adult.
    • The money cannot be transferred back to the donor from a child's custodial account, because the original transfer was an irrevocable gift. Once the money has been given to the child, it is owned by the child. The child does not have the authority to gift the money back to the parent and the custodian would be violating his or her fiduciary responsibility if he or she transferred the money back into his or her own name or used it for personal benefit.
    • However, nothing prevents the custodian from spending the money for the benefit of the child, as long as the expenses do not benefit the custodian and are not "parental obligations," such as food, clothing and shelter.

Education Planning

Coverdell Education Savings Accounts (ESAs)

These accounts allow an individual (the nominal owner) to contribute up to $2,000 annually on an after-tax basis to pay for the education of a child (the beneficial owner), covering the years from pre-kindergarten to college in tax-free dollars. The contributor need not be related to the child and may be an entity, as well as an individual.

One may establish more than one ESA, but the annual limit that a child may receive is $2,000, irrespective of the number of contribution sources. Assets eligible for inclusion in the account include mutual funds, individual equities and bonds and certificates of deposit. Life insurance may not be contributed into a Coverdell account, however. The custodial organization may be a bank, mutual fund company or brokerage firm. The plan must have a beneficiary designation. The assets in these accounts accumulate on a tax-deferred basis. One may not fund a Coverdell account once the beneficial owner turns 18. Additionally, the account must be fully depleted by the beneficial owner's 30th birthday. Any remaining accumulations at that time would be subject to tax and penalties. Coverdell's may be rolled over to other institutions. There is a 60 day period in which to do so and one rollover is allowed per year.

Contributions to a Coverdell account that exceed the $2,000 limit are subject to tax and penalties, as well. Any withdrawals not used to pay for education may be subject to tax and penalties. The aforementioned tax implications apply at the federal level. In some states with an income tax, part of a Coverdell withdrawal may be taxable if the parent (nominal account owner) is claiming a Hope or Lifetime Learning credit.

Filers who earn at or below certain modified adjusted gross income limits may make the full $2,000 annual contributions. The limits are as follows:

- $190,000 (joint filers), phase out of contribution between $190,000 and $220,000

- $95,000 (single filers), phase out of contribution between $95,000 and $110,000

Contributions may be made as late as the tax filing deadline of April 15.

529 Plans
Named for the provision in the internal revenue code, section 529 plans are used to pay for a child's college and/or graduate education. They are considered a municipal fund security, as they are managed by a state or educational institution. Every state has established its own 529 plan, but one may use any 529 plan to pay for college expenses in any state. Contributions are not tax deductible, but withdrawals are free of federal income tax, if used to pay for qualifying college expenses. Contribution and withdrawal benefits may vary for residents of a state who use its own 529 plan. As distinct from the traditional UTMA/UGMA accounts, the custodian (nominal owner), has more control over the funds contributed to and withdrawn from a 529 plan. The earnings portion of non-qualifying withdrawals are subject to income tax and an early withdrawal penalty, much like a non-qualified early withdrawal from an IRA or ERISA qualified plan prior to age 59.5.

The state treasurer's office or third party managers, manage the 529 plan assets. Rollovers are generally permitted between plans once during a 12 month period. Contributions into these plans may be substantial. There are no age restrictions as to contributions and withdrawals. Nor are there income restrictions for making a contribution or phase-outs, unlike Coverdell Education Savings Accounts.

Health Savings Accounts (HSAs)
Established in 2004, HSAs are used to pay for unreimbursed health care expenses on a pre-tax basis. The HSA is a tax-exempt custodial account managed by an insurer or bank as trustee. One must be enrolled in a high deductible health insurance plan and not be enrolled in Medicare. The goal behind these arrangements is to motivate individuals to control their health care costs. Either the individual or employer may contribute to an has. The contributions are tax deductible and must be in cash only; no investments may be placed into an HSA. Contributions may be made as late as April 15 following the year to which the contributions apply. Qualified distributions (e.g., used to pay for medical expenses and incurred by the individual, his or her spouse and any dependents) are not taxed. MSAs (see below) may be rolled into an HSA.

Medical Savings Accounts (MSAs)

  • Archer Medical Savings Account: eligible individuals and employers may contribute to this type of plan, but not both in the same year. Contributions are subject to limitations, are tax deductible may remain in the plan from year to year until needed, and are portable between employers; employer contributions are not included in the employee's income. Excess contributions are subject to a 6% excise tax. Qualified withdrawals are not subject to income tax.
  • Medicare Advantage MSA: operates much like a traditional MSA, but is used pay for qualified medical expenses for an individual who is enrolled in Medicare.

Health Flexible Spending Arrangements (FSAs)
These arrangements enable employees to be reimbursed for medical expenses. Self-employed individuals may not establish an FSA. The employee and employer may fund these plans on a pre-tax payroll deduction basis. Contributions not spent by year's end are forfeited. Withdrawals for qualifying medical expenses are tax free.


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