Investing for a Young Child

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jps5976
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Investing for a Young Child

Post by jps5976 » Wed Mar 04, 2009 1:45 pm

Hi,

I have about 5k to invest for my daughter (she is 2), and i am considering Star or Life Strategy Growth. I preferred one of the TR funds but they are not available through the account that i need to use. Also, at this point i do not have enough to satisfy the minimums for Total Stock Market, all World FTSE ex-US, and Total Bond market, so my options are limited. Therefore, for the time being i am considering one of the above.

I am leaning towards STAR because of it's excellent diversification and seems to perform well in all markets. In regards to the Life Strategy, i am not a big fan of the Asset Allocation portion (isn't that market timing?) and am not sure how much value it adds.

Having said that, i know this will also raise the issue of holding bonds in a taxable account, since it is a UGMA account. What do people usually do in this case, because i don't want it in all stocks. I want to hold the money in a fund where there is the potential for growth, but also on the conservative side. Also, since this is money she received as gifts, i want to make sure i can give it to her as i wish, as opposed to putting it in a 529 and having it used for college. Although i do plan on opening up a 529 in the near future as well.

Any thoughts would be much appreciated.

Thanks,
Jon

mptfan
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Post by mptfan » Wed Mar 04, 2009 2:06 pm

Why use a UGMA account? I know that you want to invest for your daughter, but the money that you invest doesn't care what type of account is sits in, it will grow (hopefully) the same regardless of whether it sits in a regular taxable account, or an IRA, or a 401k or whatever. Assuming you have not already done so, maybe you should max out your retirement accounts first, and then invest the tax savings in a tax efficient regular account. At some point in the future, when you want to give money to your daughter (assuming that you want to do so before you die), you can just give her the money in the taxable account. Or, if she gets the funds upon your death, she will get them tax free because of the stepped up basis.

jps5976
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mptfan

Post by jps5976 » Wed Mar 04, 2009 2:12 pm

Mptfan -

I already max out my 401k and IRA accounts, so are you suggesting i just invest this money for her in my own account?

What is a reason for not holding it in UGMA? The money is hers either way right? Also, i would assume they are taxed the same way, no?

Thanks

mptfan
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Re: mptfan

Post by mptfan » Wed Mar 04, 2009 2:25 pm

jps5976 wrote:What is a reason for not holding it in UGMA? The money is hers either way right?
A UGMA account has restrictions that a regular account does not. For example, when the child becomes an adult, the money in the account automatically becomes theirs to do with as they wish. And I don't think most 18 year olds have the maturity or discipline to handle a large chunk of money being dropped in their lap. I know, I know, you will teach her the importance of saving and investing, but despite your best efforts, if your 18 year old daughter wanted to use the money to buy a BMW, you could not stop her. So my question to you is..... why would you take that chance if you don't have to?

jps5976
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mptfan

Post by jps5976 » Wed Mar 04, 2009 2:33 pm

understood, but she doesn't have to know that i have the account for her - having said that, any thoughts on the funds i mentioned in the original post

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Post by mptfan » Wed Mar 04, 2009 2:35 pm

You didn't answer my first question....why use a UGMA account?

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Post by dbr » Wed Mar 04, 2009 2:44 pm

UGMA is taxed to the child's tax return subject to the considerations of the so-called "kiddy tax." An account held for her by you is taxed to you.

A significant concept related to UGMA is that once money is placed in the UGMA it is an irrevocable gift to the child which must be transferred absolutely to her control at the age specified in the UTMA. As custodian a parent is liable to certain responsibilities regarding the use of the money under pain of civil suit by the child (usally having discovered the transgressions upon reaching majority). Currently assets in a UTMA are regarded by colleges and the Federal Government as child's assets for college financial aid (see FAFSA) considerations.

Typically UTMA/UGMA has been used as a tax device by parents but of marginal benefit given the increasing restrictions of the kiddy tax rules. There may be more justification in the case of grandparents or others wishing to establish gifts now for grandchildren, etc.

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NYCPete
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Post by NYCPete » Wed Mar 04, 2009 2:57 pm

I think the STAR Fund is a reasonable choice, and I would personally prefer it to the Lifestrategy Fund as you can count on the AA of the STAR fund and you can't with the Lifestrategy Fund due to the Asset Allocation fund you mentioned. While I personally prefer using only index funds, the STAR Fund is still fairly low cost with a balanced AA, and is offered by Vanguard, who is a much better steward of money than most investment firms.

I disagree with previous comments regarding children misusing UGMA money when they turn 18. True, some children will misuse the money, but others won't, and teaching and learning is sometimes about letting children make mistakes and allowing them to learn from from those mistakes.

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Peter
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Post by Tramper Al » Wed Mar 04, 2009 3:17 pm

The first few dollars of income are treated in a little more tax friendly manner if held in the child's name (UTMA/UTGA), compared to yours. You reach a point, though, above which it is all taxed at the parent's rate. Ilke the STAR, though in a UTMA you could buy any old VG ETF.

If a good chance of college expenses, why not consider a 529? You may have a tax break in your state, and no worries about taxes after that, if used for college.

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Kenster1
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Post by Kenster1 » Wed Mar 04, 2009 3:31 pm

Yes for a lot of parents where savings is mixed with their own savings -- the money becomes muddled and the parents may use for something else. Oh I needed a downpayment on that car I had to upgrade.

As others mentioned, there are tax benefits too with the custodial (UGMA/UTMA) accounts on the investment income:

$0 to $900 Tax free

Under 19 years (or if full-time student, under age 24):
$901-$1,800 --- Child's tax rate

Furthermore -- the savings doesn't necessarily have to be completely handed over to the child upon reaching 18/21 (depending on State). You may be using the custodial account for the child's benefit as they age and that's what I'm thinking too.

For example - there may be many programs out there for a young teenager that may be unaffordable for a lot of middle-income families. Specialized summer camps can be very expensive - thousands of dollars. What if my teenage daughter develops a passion for culture and languages and wishes to spend part of her summer at a specialized summer language immersion program in Europe that will cost thousands of dollars in total fees. What if my teenager develops a gift for tennis -- ranked top 10 in the State and wanting to continue with tennis in college/university and is asking to attend a specialized summer tennis camp in Florida for thousands of dollars.

So these are the types of examples where I see myself using the money in extraordinary circumstances for the child's benefit. You obviously are not suppose to use the custodial money for ordinary/normal necessities that parents provide for their child....i.e. I can't take out the money to fund my child's clothes or birthday party.
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mptfan
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Post by mptfan » Wed Mar 04, 2009 3:34 pm

Kenster1 wrote:You obviously are not suppose to use the custodial money for ordinary/normal necessities that parents provide for their child....i.e. I can't take out the money to fund my child's clothes or birthday party.
Sure you could, no one is going to stop you. You can use the money for anything.

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Post by abceater » Wed Mar 04, 2009 3:42 pm

I edited my post because I didn't see the previous one. The money can be used for anything that benefits the child.

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Post by mptfan » Wed Mar 04, 2009 3:45 pm

abceater wrote:I edited my post because I didn't see the previous one. The money can be used for anything that benefits the child.
Perhaps the money should be used that way, but it can be used for anything.

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Kenster1
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Post by Kenster1 » Wed Mar 04, 2009 3:46 pm

mptfan wrote:
Kenster1 wrote:You obviously are not suppose to use the custodial money for ordinary/normal necessities that parents provide for their child....i.e. I can't take out the money to fund my child's clothes or birthday party.
Sure you could, no one is going to stop you. You can use the money for anything.
Ok ok ok -- but what I really meant is that you're not suppose to do that. You could get caught in an IRS audit if they wanted to see what you spent that money on.

"All custodial assets must be used “for the use and benefit of the minor.” While this may be subject to interpretation, it’s clear that custodians should never use the money for expenses unrelated to the child’s interests, or for day-to-day living expenses and other expenses the custodial parent or legal guardian is legally obligated to pay."

You can also certainly try to defraud the IRS on your Schedule D as well -- oh I only gained a small amount (x%) on the sale of my stocks because I sold my stocks based on highest cost-basis lots. The IRS has to take your word for it because that info isn't specifically provided to them directly. The problems comes during an audit and then you have to prove yourself.

Again - in my case, the bigger bulk of the savings for the child will be in the 529 plan. A custodial account will of course affect financial aid but I don't plan on handing over a large sum of money (e.g. $30k) when they reach 18. I plan on using most of it for their benefit prior to hitting college.

My understanding is that for those who want to gift or transfer large sums of money to their child (tens of thousands per year) then a trust as part of an estate plan would be a better bet.
Last edited by Kenster1 on Wed Mar 04, 2009 3:52 pm, edited 1 time in total.
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mptfan
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Post by mptfan » Wed Mar 04, 2009 3:50 pm

Kenster1 wrote: Ok ok ok -- but what I really meant is that you're not suppose to do that. You could get caught in an IRS audit if they wanted to see what you spent that money on.
Agreed. But in the real world, your chances of getting audited over the withdrawal of funds from your child's UGMA account are, I suspect, close to zero. Consider all the Ponzi schemes and all the investment fraud and tax fraud that went on for years and years and cost billions and billions of dollars with no oversight. And even if you were audited, I'm sure you could come up with some spending that was for the child's benefit, like medical costs, education expenses, etc. to justify the withdrawal, and never be subject to any penalty.

EDITED TO ADD: The IRS probably doesn't care why you withdraw money from a UGMA account anyway, because doing so does not avoid the payment of income taxes. In fact, they probably want you to withdraw the money so the funds lose their tax advantage. So while you may be defrauding your child, you are not defrauding the IRS.
Last edited by mptfan on Wed Mar 04, 2009 4:06 pm, edited 2 times in total.

dbr
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Post by dbr » Wed Mar 04, 2009 3:56 pm

mptfan wrote:
Kenster1 wrote: Ok ok ok -- but what I really meant is that you're not suppose to do that. You could get caught in an IRS audit if they wanted to see what you spent that money on.
Agreed. But in the real world, your chances of getting audited over the withdrawal of funds from your child's UGMA account are, I suspect, close to zero. Consider al the Ponzi schemes and all the investment fraud that went on for years and years and cost billions and billions of dollars with no oversight. And even if you were audited, I'm sure you could come up with some spending that was for the child's benefit, like medical costs, education expenses, etc., and never be subject to any penalty.
As I read the landscape the only practical way that custodians actually get caught up in misuse of these accounts are when the children themselves sue for misuse of or failure to transfer funds. For that to happen the issue has to be substantial enough to encourage a lawyer to actually bring action. There are some anecdotes over on Fairmark.com illustrating some of the situations people get into.

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Post by abceater » Wed Mar 04, 2009 4:12 pm

"All custodial assets must be used “for the use and benefit of the minor.” While this may be subject to interpretation, it’s clear that custodians should never use the money for expenses unrelated to the child’s interests, or for day-to-day living expenses and other expenses the custodial parent or legal guardian is legally obligated to pay."
Where are you getting this quote? I'm asking because from my reading there is absolutely nothing illegal about using the money for something that the legal guardian is legally obligated to pay.

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Post by Kenster1 » Wed Mar 04, 2009 4:39 pm

abceater wrote:
"All custodial assets must be used “for the use and benefit of the minor.” While this may be subject to interpretation, it’s clear that custodians should never use the money for expenses unrelated to the child’s interests, or for day-to-day living expenses and other expenses the custodial parent or legal guardian is legally obligated to pay."
Where are you getting this quote? I'm asking because from my reading there is absolutely nothing illegal about using the money for something that the legal guardian is legally obligated to pay.
Yeah - some places take the more strict interpretation on the usage of the custodial account to be on the safe side.

But you're right -- according to Fairmark....
http://www.fairmark.com/custacct/spend.htm

...it seems that the rules are pretty liberal on how you use it so long as it's for the benefit of the child. So I guess that big birthday party at Chucky Cheese seems to be ok or just about anything for the benefit of the child. The rules are liberal and gray.

However they do say:
IRS rulings on custodial accounts create a concern that if the account is used for expenses that are within the parents' support obligation, then the parents may have to pay additional tax. It's a gross exaggeration to suggest that these rulings mean you can't use a custodial account in this way, or even that you shouldn't use a custodial account in this way. The rulings do not in any way imply that it is improper to use custodial money for the minor's support. They simply provide a tax rule that applies when this happens.
The rules are loose and liberal and I guess you should be fine as long as you stick to using the money for the benefit of the child.

I think where a parent might be crossing the line in using the custodial account as noted in the link is if in the case of a divorce, the parent paying the child support takes money out of the custodial account to make the child support payments thinking that it's perfectly fine since the money is for the benefit of the child. I think that's crossing the line as child support payments are basically legal income/support obligations and so it would be wrong to take the child's money from their account to fund child support payments for their basic living needs.
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Re: mptfan

Post by Ken Reckers » Wed Mar 04, 2009 6:39 pm

jps5976 wrote:any thoughts on the funds i mentioned in the original post
I have a taxable acct for daughter (actually in a trust) with small amount and am using STAR until we grow it to 3K, then I plan to change it to TSM, eating any tax bite I have to make. I don't mind Life Strategy Growth as much as other people, and you have the balance to open it. I would probably just use TSM alone with your amount, but STAR or LSG sound good to me.

You also could try Fidelity Four in One, if it's available and if it has the mix you like.

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Post by jps5976 » Thu Mar 05, 2009 10:01 am

I just had a few follow up questions based on a lot of the above responses.

Just to recap - i have opened a UTMA for my 2 year old daughter, and i now want to open an account for my 1 month old daughter as well.

I want to fund these accounts with money they have received from birthdays, christenings, etc, so that i may give it to them one day.

Within the next year i also plan to open a 529 for each for the specific purpose of funding a college education.

Based on the above comments, my questions are ...

1) What do people feel is the best way to hold investments for a child? I understand that if i keep it in a UTMA it is an irrevocable gift which they technically get at age 18. My approach to this is that they won't know that they have it until i am ready to tell them and give it to them - there is no way for this to be enforced. However, the downside is it will hurt any financial aid package come the college years, which is a big deal since this money will be invested for the next 18 years.

2) If i decide to hold the investments in my own name, how would i split the positions between my two daughers, assuming i invest the same way for both of them? Just keep track of how much each contributed?

Any thoughts?

Thanks again,
Jon

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Post by dbr » Thu Mar 05, 2009 10:43 am

You may have a misimpression about the UTMA. The gift is realized when you fund the UTMA, not when you finally decide to "give it to them." There is no "technically" about it. My understanding is that the enforcement mechanism is civil suit of the children against the parent or whoever the custodian is at the time of age. Note it is possible you could be deceased then and someone else will be custodial and subject to civil liability. In my opinion hiding the existence of the account after the age of transfer (which is not necessarily 18) would be immoral. Not being honest with one's children can also be a bad thing. Note another issue is that if you as parent and custodian or someone else as custodian screws up the child's tax reporting during the time they don't know they have the account or can't manage tax reporting, then you will also leave them with an unwanted legacy with the IRS. This becomes less than amusing after the point when they should have had the money outright, have other sources of taxable income, and are filing as adults. Each is on their own regarding the possible downside to turning loose young adults with significant amounts of money they did not earn themselves. The outcome is highly individual dependent.

All of that said, a UTMA that is only invested, never withdrawn, and about which the parent is honest with the children, transferring the account at the designated age, and with no funny business in the tax department will probably be a much appreciated benefit for your children.

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Post by tarnation » Thu Mar 05, 2009 11:00 am

Just to throw out another option, since they don't NEED to take risks with the money and you are looking at a long time line, you might consider opening a custodial account at treasury direct and buy TIPS (can do it with as little as $100).

The account is under their SS#, so kiddie tax would ameliorate the phantom income tax problem. Also, I think it is a prudent investment that satisfies requirements for fiduciary responsibility.
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Post by Bounca » Thu Mar 05, 2009 11:17 am

Since when do all 18 year olds take there UGMA/UTMA money and by a BMW or sue the parents? Thats the common theme I'm getting here. :roll:

Good lord I'm a horrible father for having a tiny side stash of funds in my daughter and sons UGMAs.

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Post by jps5976 » Thu Mar 05, 2009 11:26 am

DBR - i think you are misinterpreting what i am saying.

Obviously the gift is there for my children when they reach a certain age and i have every intention of giving it to them as a gift one day. I remember how happy i was when i was about to get married and my parents told me "here you go, we've had these stocks for you since you were young". I was ecstatic and very appreciative of the gift, and i will do the same for my children.

So the fact that the minute i turned 18 and my parents didn't say, by the way here's $20k in stocks we've saved for you, does that make them immoral or corrupt? that's ridiculous.

I think you were missing the point of my questions. My questions are asking about the best vehicle to save for them, and the pros and cons of each.

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Post by dbr » Thu Mar 05, 2009 2:27 pm

If the only real question is what investment vehicle to choose and you already think a balanced allocation to domestic and international stocks and total domestic bond market is attractive you can open whatever kind of joint or custodial account you want at a broker and buy the ETF's VTI, VEU, and BND. There are no minimums and no trading restrictions.

I apologize for the legalistic tone about UTMA's, as, of course, virtually all of us are not schemers conducting nefarious acts with UTMA's nor are most of the children we raise likely to behave like idiots just because we parents did a good thing for their benefit.

On the other hand there are stories like these:
http://fairmark.com/forum/read.php?4,36162
http://fairmark.com/forum/read.php?4,32886
http://fairmark.com/forum/read.php?4,31827
http://fairmark.com/forum/read.php?4,32000
http://fairmark.com/forum/read.php?4,31495
http://fairmark.com/forum/read.php?4,31656
http://fairmark.com/forum/read.php?4,31263
http://fairmark.com/forum/read.php?4,30634
http://fairmark.com/forum/read.php?4,29711
http://fairmark.com/forum/read.php?4,28030
etc.

To be more constructive, my view would be that one does not save for one's children as such. Doing so is a form of mental accounting. What one does do is plan one's overall financial condition to meet the expected obligations one will have in one's lifecycle, including providing children with a college education or granting them a nest egg when they start out. It is not necessary from an investment point of view to designate specific investment vehicles to accomplish this.

I would say that accounts such as separate joint accounts, custodial accounts, trusts, education savings plans, etc. are chosen because there are specific tax advantages or because there are specific contingency issues regarding how to preserve children's interests against divorce, demise or incapacity of the parent, etc. UTMA's serve the purpose that the gift is irrevocable by honorable custodians and have certain tax advantages arrayed against a list of some minor, some possibly major restrictions and unintended consequences. Joint accounts enable the comfort of mental accounting at the cost of administrative complication and unintended consequences. Trusts solve certain problems that are important if they are and bring certain contingencies and restrictions. Education savings plans offer tax benefits, mental accounting benefits, and restrictions.

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Post by justj2k78 » Thu Mar 05, 2009 6:10 pm

My phiposophy for my children (1 year old daughter, 2nd due any day), is very simple, and probably not the recommended strategy.

I put $50 into a savings account each pay day (every 2 weeks), and I will do this until the time they go to college. As of today, I believe this account earns 2.15%. Without interest, they will have $23,400.

When it comes to my retirement, I am quite agressive. I have a lot of time. However, I don't consider 18 years to be truly "long term". My risk tolerance for this money is essentially zero. My plan is to offer my children the opportunity to attend a SUNY College on dad, and if they would like to go to a private school, they will have these funds as a start. And if they get a full ride through college? They would get quite a graduation present after college.

I realize this is probably not what most would recommend. But to me, this money is sacred. I don't want it involved with the stock market.

Perhaps they won't have quite as much as they would have, had I put this money in a 529. But, it also won't come back at a loss. And with the intent of this money, it's a chance I'm not willing to take.

Just throwing out another opinion, and it is the opinion of an admitted newbie!

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Post by Horatio » Thu Mar 05, 2009 10:39 pm

jps5976 wrote:

2) If i decide to hold the investments in my own name, how would i split the positions between my two daughers, assuming i invest the same way for both of them? Just keep track of how much each contributed?
You could still have separate accounts in your own name.

We have UGMA accounts for our young children. The first $900 income is tax free. Rest is taxed at our rate so no further advantage there. The accounts are funded like yours with birthday & holiday gifts from relatives. The accounts are small. It's hard to generate $900 investment income these days!

We also have trusts for them, established by their grandparents. One advantage of a trust is that it is not automatically turned over to them at age 18.

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Post by jps5976 » Fri Mar 06, 2009 4:00 pm

My only problem with the UTMA is the fact that it can hurt you when you apply for financial aid when your kids are ready to go to college. To me, that is complete BS. If i want to save money for my child to go to school one day in the future, it should not be held against me.

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Post by djorg » Fri Mar 06, 2009 4:45 pm

jps5976 wrote:My only problem with the UTMA is the fact that it can hurt you when you apply for financial aid when your kids are ready to go to college. To me, that is complete BS. If i want to save money for my child to go to school one day in the future, it should not be held against me.
This is the point I wanted to make. To be specific (going by my vague long-term memory), college fin aid suggests that 35% of students' assets go to college per year in school, and UGMA falls into that; whereas I think it's 5% (possibly 10%) of parents' assets. My gut feeling says this outweighs the tax advantages. My parents put a significant amount of money in UGMA for me (before the advent of 529's or Coverdells), and I paid it all out to school. Unless your kid doesn't go to college, all of that money will be gone before they are 21 and with fewer tax advantages than a 529 or the like. IMO, either keep it in your own account or put it in a college vehicle.

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Post by dbr » Fri Mar 06, 2009 5:02 pm

It can happen, of course, that the family will be wealthy enough to not qualify for financial aid at all, UTMA or not, in which case the concern is eased.

A single very large factor in financial aid is to be sure all your children are in school at the same time.

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Post by Horatio » Fri Mar 06, 2009 6:03 pm

dbr wrote:It can happen, of course, that the family will be wealthy enough to not qualify for financial aid at all, UTMA or not, in which case the concern is eased.
Honestly, this is our goal. It was looking more attainable before the 529's lost their value. But we are still planning to get there, hoping to cover their tuition. In that scenario, we would turn over the UTMA accounts to them to contribute partly for school expenses and partly to be their own money upon leaving for college.

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Post by jps5976 » Tue Mar 10, 2009 3:19 pm

I was speaking with a financial planner today and i wanted to share what we discussed because it helped clarfiy a great deal for me. All of the info i am about to provide was confirmed with the firm's lawyers.

1) True, a UTMA is an irrevocable gift, but if you were to withdraw money out of the account, nothing is reported to the IRS. The only possible recourse to doing so is if your child knew about the account. For example, if you decided to take the money out and blow it all on yourself, and your child (assuming a teenager in this case) knew about it, they can take legal action against you. Otherwise, you can do whatever you want. Having said that, they did suggest you keep a record of what you do with the money, should the need ever arise.

2) While calculating financial aid with FAFSA, 20% of the value of the UTMA is counted in the formula against you, whereas if you keep everything in your name, 5.6% of the parents' total investments are counted. Depending on how much money is in each account, can obviously make a difference.

Therefore this is not as much of a clear-cut decision as i originally thought. You have two weigh the potential tax free growth of a 529 vs keeping the money in a UTMA and having it count against you at a higher rate, vs keeping it in your own name and taking a huge tax hit when you want to give it to your child.

I just found my conversation today very helpful and figured i would share it with everyone.

Thanks

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