Ugh! UTMA Confusion!

Can we use our daughter's UTMA funds to pay for softball lessons and after-school tutoring?

The Uniform Transfers to Minors Act (UTMA) is very generous when it comes to spending the money held in an UTMA account, which is basically an investment account set up in a child's name and managed by a custodian (usually the parent) until the child reaches the age of majority for the state (typically age 21). At that point, the account beneficiary can do whatever he or she chooses with the money. But until then, the custodian is allowed to access the account for anything that directly benefits the beneficiary — so long as it's not part of normal support obligations.

In other words, a parent can't use UTMA funds for groceries, clothes or child-support payments, but can feel free to spend the money on treats like after-school classes, a trip to Europe or even a car, says Kaye Thomas, a tax lawyer and founder of Fairmark.com, a Web site dedicated to tax issues.

Since UTMA accounts are subject to state law, the withdrawal rules vary from state to state. But generally speaking, you shouldn't have any trouble spending money on extracurricular activities or even educational expenses, says Thomas. Softball lessons and a private tutor are probably fair game. A more questionable use of the money would be, say, a down payment for a new house, even if the purchase allowed you to put your child in a better school. True, that does benefit the child, but it isn't a direct benefit, Thomas explains.

As you no doubt already know, the beauty of an UTMA account (and its older sibling, the Uniform Gifts to Minors Act, or UGMA) is that gains are taxed at the child's rate, which is typically a whole lot lower than an adult's rate. That said, children are still subject to the Kiddie Tax, which stipulates that until a child turns 14 years old, any income above $1,600 (for 2004) will be taxed at the parents' rate. (The first $800 of income is tax-exempt and the next $800 is taxed at the child's rate. For children older than 14, the first $800 is still tax-free.) Nonqualified withdrawals, on the other hand, are to be reported on the parents' tax return, so they're also taxed at the parents' rate.

Unfortunately, because of the Kiddie Tax, an UTMA account that generates a lot of annual income or a large UTMA withdrawal (that's subject to capital-gains tax) could be taxed quite substantially. "You don't want to let taxes determine your course of action, but you obviously want to take that into account," says Martin Nissenbaum, national director of retirement planning and taxation with Ernst & Young in New York. If the parents sell for a profit that's a lot more than $1,600, he says, "then they really haven't gotten the tax benefits of having put the money in the child's name."

Nissenbaum suggests that parents with younger kids sell only as much stock as necessary to generate $1,600 or less per year in capital gains from the UTMA account, and look into their own savings or investment portfolios (if any) for the rest of the money that they may need. Alternatively, they can leave the UTMA account to grow for a couple of more years and once the child is 14, take advantage of the lower taxes. Better yet, thanks to the tax cuts of 2003, the gains in UTMA accounts will be tax-free if sold in 2008.

"If waiting a couple of years won't make a difference from an economic perspective, then why pay three times the tax?" Nissenbaum asks. That is, of course, if you're not expecting the account's value to crash in the next three or four years.

If you need more detailed information on UTMA accounts, Kaye Thomas' online guide to custodial accounts for minors is quite useful. For more on the tax rules for children, read IRS Publication 929.