UTMA Regret, Part III

Third in a series on escaping from custodial accounts.

This is the last in a series of three columns dealing with what I call UTMA regret: the desire to undo a transfer to a custodial account established under the Uniform Transfers to Minors Act. My previous two columns provided an overview of the subject and a discussion of three techniques for handling this problem. Here are three more.

Illiquid investments

If your UTMA regret springs from a fear that an immature child will waste the assets of the account, one possible solution is to put the money in an illiquid investment. Some people have used family limited partnerships; more recently I have heard that annuities are being used for this purpose. These ideas can be effective, yet they raise tax and legal issues:

Is this just a transparent way to defeat one of the basic requirements of the Uniform Act? If so, is it possible a court will require the custodian to replace the illiquid asset with a liquid one — perhaps even from the custodian's own assets, if it isn't possible to unwind the existing investment?
Is this a violation of the duty of the custodian to invest the assets in an appropriate manner for the benefit of the minor? If so, is it possible a court would declare the custodian personally liable for the poor performance of this investment?
Does this action cast doubt on whether the original transfer was a gift of a present interest for gift tax purposes? If so, does that mean the annual gift tax exclusion is not available for the transfers?

These are questions, not answers. Most people who use this technique are trying to preserve assets for the benefit of the minor rather than trying to do something improper. And the possible problems mentioned above may come up rarely or never. Still, it's worthwhile to think about these issues, as well as the issue of having your child feel he or she was cheated out of an opportunity to gain access to what was rightfully his or hers.

Substituted spending

You're not required to leave an UTMA account untouched until the child gains control. The custodian can spend money from the account for the benefit of the child. Naturally you don't want to spend it frivolously or improperly. Most people are already spending money on their children, however. You may be able to spend those same dollars from the UTMA account. Then take the dollars you would have spent on the child from other sources and contribute them to a trust or an education IRA, if that's appropriate. I call this substituted spending. If you don't step over the line, this is a completely legal way to shift money out of an UTMA account.

Where is the line? The spending has to be "for the use and benefit of the minor." Those words are subject to interpretation, of course. The more aggressive you are in your interpretation, the more risk there is that you may be considered to have acted improperly. It's important to keep records of how the money was spent.

It seems to be an item of faith among experts that one area is off limits. I read over and over again that you can't use money from a custodial account to pay for expenses that are within your support obligation for the child. That's clearly incorrect. At the worst, there is a tax issue if you do this, but it isn't clear that the tax rule applies to UTMA accounts, and even if it does, the cost may be relatively small in may cases. Click here for a detailed discussion.

Lay down the law

This is a simple, pragmatic approach that doesn't solve all problems but may work in some situations. Simply tell your child that although he has a legal right to do whatever he wants with this account now that he's 18 (or 21, as the case may be), you expect him to leave it alone and use it only for college, or down payment on a home, or whatever. Chances are you wouldn't be experiencing a lot of UTMA regret if this sort of dialog would leave you feeling comfortable that you've solved the problem. But you may be pleasantly surprised. You don't lose your parental authority just because the law says your kid can take the money. Apart from any strings you still hold — such as the likelihood of more money in the future — kids generally respect their parents, even if they seem loath to admit it. If your UTMA regret stems from fear that the child will waste the money, consider whether you can deal with the situation by simply forbidding unauthorized use of the account.

Get over it

You may not think much of this suggestion as a way to deal with UTMA regret, but it's an important one to consider. Get over it. Accept the fact that the money belongs to your child, and control has passed out of your hands. Let it be a learning experience — for both of you. Imagine what your child will tell you 10 years from now. Can you see your child saying something like this?

It must have made you nervous to let me get my hands on so much money back then. But it meant a lot to me that you could trust me.