UTMA Regret, Part II

Second in a series on escaping from custodial accounts.

In my previous column, I examined what I call UTMA regret: the desire to undo a transfer to a custodial account established under the Uniform Transfers to Minors Act. I pointed out various reasons for UTMA regret, and discussed in general terms the propriety (or impropriety) of trying to undo such a transfer. Now it's time to look at specific approaches. I've come up with six different ways of handling the situation. This column discusses three of them.

Just take it

I know, it's shocking that I would even mention this possibility, in public no less. It kind of confirms the worst you've heard about lawyers, doesn't it?

Before you pass judgment, I'd like you to meet Dan. He put $500 into an UTMA account for his daughter, Laura, six weeks ago. This was intended as the start of her college savings. Then Dan figured out this wasn't a smart way to save for Laura's college expenses.

Here's what Dan plans to do. He'll withdraw the $500 from the UTMA account and shut it down. Then he'll put the money in another account for Laura's education — perhaps a Coverdell account or a 529 plan, or maybe just a regular brokerage account that names Laura as the death beneficiary and will be maintained solely for her benefit.

Will Dan go to jail if he does this? Will he have cheated Laura? Or the IRS? Committed financial aid fraud? The answer to all of these questions is no. Dan is guilty of poor planning when he set up the UTMA account, but he's not guilty of anything more serious than that.

Yes, Laura has a right to the $500 and may have the right to sue for it. So what? Dan plans to keep it aside for her anyway. How likely is it that Laura, or someone acting in her behalf, will start a legal action in these circumstances?

There are certainly circumstances where it is grossly improper, and perhaps even criminal, to remove money from a custodial account. Warning bells go off if the account was set up with money from a source other than the custodian (from a grandparent, for example); or if the account has been used to deflect taxes to the child and now will go back to the parent; or if the account existed for some time and was removed from the child's name shortly before applying for student financial aid; or if the money removed from the account will not be securely set aside for the benefit of the child. In these and perhaps other circumstances, you should be reluctant to use your power as custodian to remove money or other assets from the account. But this method is out there as a possibility, and in very limited situations may not be improper. Repeat: very limited circumstances.

One point you should be aware of is that taking the money from the custodial account may shift income taxation of the account to you. For example, suppose you invested the account in stocks that rose in value. You sold the stocks, then took the money from the account. It's possible the IRS would say the gain from the sale is your income, not your child's.

Transfer to trust

Now let's meet Sara. When she set up an UTMA account for Philip, she imagined that college expenses would eat up the entire account and then some before Philip turned 21. But he dropped out of college after a single semester, when the account still had over $28,000. Since then the account has grown to $37,000 and Philip has had a succession of low-paying jobs, generally of the type that won't interfere with his social life or his desire to sleep until noon. His only apparent ambition at this point in life is to destroy his parents' eardrums with indescribably horrible music.

Philip will grow up, eventually, and do something useful with his life. Sara feels quite strongly, though, that turning over the $37,000 that's in the UTMA account at this point isn't the right thing to do. Apart from the likelihood he would waste the money, this amount of wealth will destroy whatever minimal incentive Philip now has to be productive. Sara wants him to have the money, but not now. The answer may be a trust.

I generally encourage anyone who is planning to transfer a large dollar amount to a child to consider a trust before setting up a custodial account. It rarely makes sense to put tens of thousands of dollars into a custodial account. The cost of setting up a trust is often quite small relative to the benefits it provides in comparison to an UTMA account when the dollar amounts being transferred are large.

Once the money is in an UTMA account, though, there are some tricky legal issues in trying to get it into a trust. Even if your child will consent to the transfer, the consent of a minor may not be valid. You may not be able to get your child's consent; you may not even want the child to know what you're planning. There may be other issues as well, including transfer tax issues. These issues are the province of a knowledgeable estate planning lawyer.

Some of the issues may depend on the laws of your particular state. Be prepared to learn that you can't properly transfer the UTMA account to a trust. Okay, then, what if I do it anyway? I don't think Philip is going to sue me. If he does sue me and ends up with the account, I'm no worse off than I am now. What else can happen? These are the kind of tough questions to ask your lawyer.

Return gift

Suppose your child wants to make a handsome gift to someone who has helped him a great deal. A rare book costing $150 for an inspirational teacher, for example. I don't see why the child can't make that gift. And I don't see why you couldn't provide the money for that gift from an UTMA account. You're allowed to transfer money from the account to the child even before the child is 18.

Can we extend that thought to the possibility of the child making a gift of the entire account — to you? Your child might be willing to do this if she sees that you are in need, or if she expects to receive gifts from you in the future. But is this a valid way to undo an UTMA account?

The answer may depend on circumstances. If you and your child are collaborating on an attempt to cheat on a student financial aid application, you may be buying some trouble (student aid fraud can be a criminal offense), and you're certainly teaching your child an unfortunate lesson. The answer could be different in other circumstances, for example, if the reason for the transfer is to help the family through some unexpected financial crisis.

If you're talking about a lot of money, it's a good idea to consult with a lawyer. For one thing, a gift tax return may be required for a transfer of more than $10,000. For another, the child may be entitled to rescind the gift upon reaching the age of majority. It's best to understand the legal consequences and document your actions properly.

More to come

My next column — the last in this series — wraps up the subject with more ways to handle UTMA regret.