UGMA/UTMA Accounts vs. 529 Plans for Children

If you are a parent or a grandparent, you're probably thinking about saving money and investing for your kids or grandkids' future. Maybe you want to save for their college education. Or maybe you just want to save now to give them a nest egg to start their independent life with when they graduate. You have two main options for the types of accounts to use for saving on behalf of a child.

UTMA / UGMA Accounts

A UTMA account is a "Uniform Transfer to Minors Act" account; a UGMA account is a "Uniform Gift to Minors Act" account. They are really the same thing, but different states call them one of those two names. When you create a UTMA or UGMA account, you name the child as the beneficiary and yourself as the custodian of the account. UTMA accounts convert to the child's control at age 21, UGMA accounts convert at age 18 (again, depending on the state). Contributing to these accounts is not reversable; you cannot take the money back out for your own use (or "ungift" it) later. Here's a more detailed explanation of the differences between these two closely-related account types:


Difference Between UGMA and UTMA

A downside of UTMA/UGMA accounts is that the income from the investments is taxable in the child's name. "Kiddie Tax" exemptions apply, so as long as the account doesn't earn too much income, it won't be a burden. But if the account generates a lot of income (dividends or capital gains), you will have to pay taxes on some of it.

What is the Kiddie Tax?

Here's more on the "Kiddie Tax" rules from the IRS:

Tax on a Child's Investment and Other Unearned Income (Kiddie Tax)

An upside of these accounts is that the child can use the account for anything they want when it converts to their control (like their first house), or can be used for anything for their benefit (like college) before that age, if you (the account custodian) approve it.

Another good thing about these accounts is that you can create a UTMA/UGMA with nearly any broker or mutual fund company. So if you want to buy individual stocks or create a portfolio of mutual funds for your grandchild, this is probably the way to go.

529 Plans

A 529 Plan account is similar to a UTMA/UGMA account, except it has the advantage of letting the money grow tax free (like a Roth IRA), but the disadvantage that it must be used only for education expenses. Here's a primer on the basics of 529 Plans:

What is a 529 plan?

Ameliorating the education-only requirement, the account's value can be transferred to anyone else in the family if the child doesn't need the money. Say they are brilliant and get a full scholarship to college, you could transfer the account balance to their sibling's 529 plan, or you could even use it to go back to school yourself.

Another downside to this kind of account is that they tend to have limited investment options within the account. You might only be able to invest in a single target date fund, for example (that's the way it works for me in Maryland).

These plans vary from state to state. Your own state might offer you a tax deduction for contributing to one. If your child (or grandchild) lives in a different state, there might be advantages to investing in his or her state's plan instead. This link will help you find plans for various states:

529 Plans by State

Conclusion

Whether to invest through a UTMA/UGMA account or a 529 Plan can be a complicated decision, given all the trade-offs. Here's a link summarizing and comparing UTMA/UGMA vs. 529 Plans:

Quick Guide: 529 vs UGMA/UTMA

If you're confused after researching all the options, you might want to talk to a financial planner or tax advisor to decide which one is best for your situation.

Paying or Avoiding Taxes on Dividends from Foreign Companies

When American companies pay you a dividend, your brokerage tracks them and sends you a 1099-DIV form at the end of the year adding them all up. If the dividends were paid in a regular brokerage account, you pay tax on them on your annual IRS tax return (anywhere from 0%-40% depending on your tax bracket and the type of company paying the dividend, but most average investors pay 15%). If your stock was held in a tax-advantaged account (like an IRA), you don't have to pay tax on it.

But when a foreign company pays you a dividend, often you will see on your brokerage statement that the tax was paid immediately to that country and debited from your account. But not always...

Some countries have tax treaties with the US to either not charge dividend tax to Americans or to at least respect the US's tax-free holding status in IRAs, but most countries don't. For example, A Canadian company will tax your dividends in a regular account, but will not charge you tax in an American IRA. As another example, Panamanian companies won't charge you tax at all in either kind of account thanks to their own treaty. But many other countries take their tax out either way.

Generally, I hold foreign dividend payers in my regular taxable account instead of my IRA, because then I can at least claim the foreign tax as a credit on my income taxes to reduce what I pay Uncle Sam. I make exceptions for companies from those tax-treaty countries like Canada, Panama, and the UK though, and hold those in my IRA.

More in-depth reading about foreign dividends and taxes:

• How to Avoid Foreign Dividend Withholding Tax
• Withholding Tax Rates By Country For Foreign Stock Dividends
• Stocks That Avoid Unrecoverable Foreign Dividend Withholding In Tax Deferred Accounts
• Foreign Tax Credit And Withholding Tax Rates

Some of those are a few years old, so the specific tax rates may be out of date, but the general explanation is there. Google the headquarters country on a case-by-case basis when thinking about buying a foreign company to decide which account to buy it in.

I'm not a tax advisor; you should talk to your own advisor for specific advice about your portfolios and the companies involved.

Sources for Learning to be a Great Investor

Learning to be a great investor is as much art as science, and can best be learned by reading and listening to as many diverse sources as possible over many years.

Books

My own favorite investing books are:

• "One Up on Wall Street" by Peter Lynch
• "The Little Book that Builds Wealth" by Pat Dorsey

Other related books that I found relevant to investing:

• "The Signal and the Noise" by Nate Silver
• "Thinking, Fast and Slow" by Daniel Kahneman

Shareholder Letters

Another good way to learn is to read shareholder letters from some of the best investors out there. And fortunately, these are published for free on the internet.

• Warren Buffett's letters to shareholders of Berkshire Hathaway
• Howard Marks shareholder memos for Oaktree Capital

Blogs

These are some of my favorite blogs about investing:

• Reformed Broker
• Wealth of Common Sense
• Farnam Street
• Collaborative Fund
• Rational Walk
• The Vantage

Podcasts

There are tons of good podcasts out there that interview people from finance and business, if you have time to listen on commutes, at the gym, or folding laundry. My favorites are:

• "Invest Like the Best" by Patrick O’Shaughnessy
• "Masters in Business" by Barry Ritholtz
• Motley Fool Money by Chris Hill & Friends
• Rule Breaker Investing by David Gardner

Reddit

Do you use Reddit? There are several good investing subreddits:

• r/investing
• r/finance
• r/SecurityAnalysis
• r/ValueInvesting
• r/IntelligentInvesting

Investing in Stocks: How to Get Started?

I'm not a financial advisor, but here's what I tell people when they ask me how to get started investing.

1) Get your finances in shape otherwise. Low debt (except mortgages), no credit card debt, build an emergency savings account of a few thousand dollars (in case of short-term, unexpected money needs like your car dies or you get laid off).

2) Open an on-line, discount brokerage account with anywhere from $1k-$5k that you could afford to lose in the short run. Stocks don't always go on a straight upward line like interest on a bank account. Even great companies go up and down in the short term, though over 5-7 year spans, good companies go up overall.

If you can afford to put this money away for decades without withdrawing it, you can open your brokerage account as an IRA account (Roth or Traditional), giving you decades of tax-free growth until you reach retirement.

3) Buy stocks in dollar quantities. $500 per stock is a good starter amount where a $5 trade commission is only 1% of your total investment. Don't worry about the number of shares. If $500 buys you 3 shares of ABC, that's fine. If $500 buys you 20 shares of XYZ, that's fine too. Lots of people believe you have to buy 100 shares at a time or you have to be rich to have a brokerage account, and that's not true anymore (it was true 30 years ago, but the idea persists).

4) Strive to add money to your portfolio account over time, buying new companies or adding to the ones you already own, in those same moderate-sized increments. 10-15 stocks in a diverse range of industries is a good goal for a new investor to reach after the first few years of investing. Don't put all your eggs in one basket (or all your money in one stock).

5) If you're still unsure of what you're doing, a good way to start investing is with a low-cost index fund, like an S&P 500 index fund.

Want More Details?

Nerdwallet has a good guide to getting started. The Motley Fool also has a good guide to the basics. Both sites are credible sources for new investors.

Should You "Buy in Thirds"?

Let's say you want to invest in a company. Should you buy now? Should you wait for a correction? Will that correction ever come? What if the stock goes way up tomorrow and never comes back to today's price, even with a correction? I don't know the answers.

Buying in Thirds is a way to shift some risk around. If you want to invest $1500 in a company, buy $500 worth of shares today, $500 more a few months from now, and $500 a few more months after that.

Risk is not created or destroyed, but spread around differently. You avoid some of the risk of buying now, only to see the price go down. But you gain some risk of not buying it all now, only to see the price go up later. If the price does go down, you can buy your next batch at the lower price. If the price does go up, well at least you got your foot in the door at the lower price.

You are adding "time diversification" to your portfolio by buying the same company at different prices over time, sort of (but not exactly) like dollar cost averaging.

If you are wavering over whether to buy or not, buying in thirds also helps you ease into your ownership position instead of having to make an all-or-none decision today. In the long run, repeated over many stocks over many years and through full market cycles, the risk and luck should even out.

Arguably, things also even out at the big-picture portfolio level if you buy every stock all at once, and there's debate among investors about whether "time diversification" is a fallacy. Buying in thirds can still be useful, even if you view it as mostly an effort to control your emotions and manage cognitive biases.

Secondly and equally importantly, depending on how much cash you have on hand and whether you're regularly adding cash to your portfolio, buying in thirds is a good way to slowly establish larger positions in stocks when you don't have all the cash up front. It's useful as a way to get stock diversification in your portfolio earlier in the process of portfolio building. Keep your "third" purchases big enough that your commissions don't end up as a significant part of the cost of the stocks though. If your brokerage charges $4.95 commissions now, you could buy my hypothetical $500 worth of a stock and the commission would only be 1%, which is reasonable to me (many people say 2% is fine too).

Here's another longer discussion about "buying in thirds" from Stock Market School.