Trust Funds vs. UTMAs

Is It Better to Gift Assets to a Child Through an UTMA or Trust Fund?

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When parents, grandparents, uncles, aunts, godparents, or other generous family members or benefactors want to gift wealth to a minor child or minor children, one of the most important decisions they will face is whether to title the assets under a state Uniform Transfers to Minors Act, also known as UTMA, or to place the assets in a trust fund. Both UTMAs and trust funds have unique benefits and drawbacks that make them ideal for certain circumstances.

And you need to know these to determine which is right for your family, or which situation can have a long-term, wide-ranging effect on how the money is protected, who controls the funds, and how the capital can be put to work.

What Is an UTMA? How Are UTMAs Structured? What Are the Advantages and Disadvantages of UTMAs?

Simply put, an UTMA is a special type of ownership arrangement established under a state's Uniform Transfers to Minors Act and serves as a way for a minor child to own property. When an asset is titled for a child under an UTMA statute, the child becomes the owner of the assets. The gift is irrevocable, meaning it cannot be undone or reversed. However, until the child reaches the age of majority as specified in the UTMA documents, or, absent a specification, as spelled out in state law, he or she has no right to access or manage the funds. Instead, the property is held in the name of a custodian for the benefit of the child.

While UTMAs can be used for nearly any type of assets, including real estate, intellectual property, precious metals, and ownership in a family limited partnership, the more common situationis facilitating a minor child's owning stocks, bonds, and mutual funds, including index funds. To that end, the easiest way to establish an UTMA is to open an UTMA custodial account with a broker-dealer.

This can be done at a full-service broker or a discount broker.

Imagine that a Missouri-based father, Thomas Smith, established an UTMA for his daughter, Jane Smith. Further, imagine he wanted to name himself custodian and desired to restrict the assets to the latest possible date under the Missouri UTMA statute, which is 21 years old. To accomplish that, Thomas would establish an UTMA custodial account at a brokerage firm, having the account and assets therein titled as "Thomas Smith Custodian for Jane Smith Under the Missouri Uniform Transfers to Minors Act Until the Age of 21" or something effectively similar. This means that until his daughter, Jane Smith, turns 21 years old, Thomas Smith has total control over the UTMA property. It is he who must make the buy and sell decisions for the investments unless he outsources the job to an asset management company.

This arrangement has some substantial benefits. Chief among these is that the assets belong to the child, not the custodian. This means that unlike a college 529 Savings Plan or a bank account with the parent listed as a joint account owner, if the parent or custodian files bankruptcy, the assets are not considered part of the bankruptcy estate because they belong to the child.

This means the money is generally out of reach from the parent's creditors (or, if the parent is not the custodian, the custodian's creditors) should financial catastrophe strike. On the other hand, it also means that the assets will count against the child when calculating financial aid eligibility for college.

The fact that the UTMA assets belong to the child also introduces some responsibility and complexity. As custodian of the UTMA, Thomas is obligated by law to act as a fiduciary for Jane. This means that he must always put the interest of his daughter above his own as it pertains to the assets in question. This is true even if Thomas was the one who originally made the gift that became UTMA property. This is a point that needs to be highlighted and reiterated. Jane has certain rights.

When she reaches the age at which the UTMA ends, she can petition a court to "compel an accounting" from the fiduciary, her father. This means her father would have to produce documents and receipts demonstrating where every penny of the UTMA money went—how much was received, how much was spent, how much was invested, the dates of those transactions, the performance of the investments, etc.—justifying if any of it was spent on Jane as being in her best interest. Further, at least one court has found that obligations that Thomas would need to cover as an ordinary part of being a parent, such as medical expenses to save Jane's life, must come from Thomas and not from the money he gifted the UTMA, as using the latter would amount to embezzlement from his daughter. There have been situations where courts have ordered UTMA custodians to reimburse a child all of the stolen or misappropriated funds plus interest and/or foregone investment income.

Also, because the assets belong to the child, the child has total and complete control over how those assets are used once he or she reaches the age at which the UTMA ends. If you put money into an UTMA expecting your child to go to dental school, nothing stops him or her from taking the cash to Las Vegas and spending it all in a weekend. This is the price you must pay for the UTMA's ease of administration, low costs, and nearly effortless upkeep throughout its lifetime (presuming you are are dealing with fairly simple assets such as common stocks and corporate bonds held by a financial institution that provides regular account statements). There are some ways to potentially mitigate this concern but they are limited. In Pennsylvania, for instance, it is possible to establish an UTMA under some circumstances that won't end until a child reaches the age of 25, significantly older than is permitted in many other states.

Though it is a misleading and inaccurate description—the wealthy are much more likely to take advantage of UTMAs than the poor, gifting their children cash, property, or securities through an UTMA—UTMAs have been described as the "poor man's trust fund" because they offer some of the advantages of a trust fund without many of the expenses and upkeep requirements. In truth, children of the wealthy often have UTMAs and trust funds.

What Is a Trust Fund? How Are Trust Funds Structured? What Are the Advantages and Disadvantages of Trust Funds?

A trust is is a legal construct created when assets are set aside for the benefit of someone who does not control those assets. For example, inter vivos trust funds are trusts created during the life of the grantor in which a person, known as the grantor, decides he or she wants to set aside property—cash, real estate, securities, or other assets—to benefit another person or group of people known as the beneficiary or beneficiaries. The grantor wants this property to be managed in a specific way, on a specific set of terms, to comply with their wishes. The grantor's attorneys draw up a legal document known as the trust instrument. This trust instrument spells out a number of provisions and details about the trust, which may include instructions as to how the money is to be invested, the conditions on which funds are to be distributed, and any number of additional items. The trust instrument names a trustee, the person or institution holding title to the assets for the benefit of the beneficiaries and who or which must act in a fiduciary capacity. Sometimes, a trust will also name a so-called "trust protector," often a close family friend, who has the ability to remove the trustee or perform certain other functions to serve as a check on the trustee's power. Usually, but not always, the grantor will be the trustee during his or her lifetime, naming a successor trustee to take over when the grantor dies or becomes incapacitated.

If the trust is irrevocable, meaning it cannot be changed or undone, the trust will get registered for its own tax identification number, file its own tax return with the federal and state governments, and pay taxes on certain non-distributed earnings. rates are compressed, so trusts hit higher tax brackets much more quickly than with individual or corporate tax filings.

A major advantage of using a trust fund is that it can be personalized to meet your needs. That is, you can tailor almost any solution provided it does not violate the judiciary's determination that it is so egregious it goes against public policy; e.g., you cannot condition trust fund payouts on the beneficiary remaining a member of a certain religion, marrying someone of the same race, or forbidding them to marry someone of the same sex. For example, you could create a so-called "incentive trust" that makes payouts based upon a beneficiary reaching certain life milestones, such as graduating from a four-year university in a time period of no more than five years with a certain minimum grade point average or matching money they put into retirement accounts on a dollar-for-dollar basis, providing them with spending money to enjoy.

Aside from the additional administrative complexity, trust funds have one big downside, which is cost. Trusts require time, effort, and some liability exposure for the trustee. Trustees, particularly professional trustees, are often compensated. For example, if you have a fairly straightforward trust fund—for example, you leave behind $500,000 for a niece or nephew with 3 percent payouts to begin on their 21st birthday and the trust distributing all of its assets on their 30th birthday—you could use the services of a large asset management firm. In that case, you lose much of the ability to buy individual securities, but, depending upon the expense ratio of the underlying mutual funds selected, your total costs except for taxes are probably going to run approximately 1.5 percent per year of principal, a fairly attractive deal. If you had a much more complicated trust, those fees could be a lot higher. 

That Leaves the Question—Which Is Better, an UTMA or a Trust Fund?

Determining whether an UTMA or a trust fund is better in any given situation depends upon a number of factors. The three most important are:

  • The amount of money you are considering setting aside for the minor child. Generally, but not always, the smaller the amount, the more likely you are going to want to use an UTMA, though it seems as if it is wealthy families that take advantage of UTMAs most, pairing them with trust funds for specific purposes.
  • The restrictions you want to place on the money. If you insist that the funds be used for a specific purpose—again, within the public policy limits permitted by the judiciary, as the money in trust is no longer yours—an UTMA is not going to be ideal.
  • The need for asset protection. Good attorneys can often use trust funds in intelligent ways to protect beneficiaries beyond what might be possible with an UTMA.

In any event, this is an area where you absolutely need to have a serious discussion with your qualified advisors, including an estate attorney, a CPA who has familiarity with trust taxation, and depending upon the assets, perhaps a registered investment advisor, particularly if you are dealing with meaningful amounts of money.