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Case Study – Custodial Accounts and Tax Planning

| March 13, 2024

The below case study explores the use of custodial investment accounts for minor children as well as the benefit of active tax management, including tax gain harvesting.

Those of you who are planning to be parents, new parents, or are already parents of a minor, may have heard of custodial accounts – which are essentially any type of financial account that one person (typically the parent) manages and maintains for another person (typically the child/minor).  A UGMA (Uniform Gift to Minors Act)/UTMA (Uniform Transfers to Minors Act) account is a type of custodial account that allows the parent to invest in stocks, bonds, and mutual funds on the child’s behalf. These funds will later be transferred to the minor at a certain age, which in California can be specified as the “age of majority” at 18 years, or “age of trust termination” at 21 years.

While any type of savings is a great idea, there are certain ways to manage an UGMA/UTMA account to best minimize future tax implications. We’ll use APPL as an example, and let’s say you were able to buy 1 share at a cost basis of $20 in the 1980s before any splits. Since AAPL first went public there have been 5 splits, and that original 1 share would today equal a total of 224 shares valued at approximately $40,800, assuming you did not buy nor sell any over the last ~40 years.

Your child is now in charge of their UGMA/UTMA account given that it has been 40 years since it was first opened, and we will assume that they are also now well in their career and potentially have a family of their own. Today, they are looking to finally sell some Apple shares; however, they will likely be looking at paying a significant amount of taxes not only due to capital gains, but also due to your child potentially being in a higher income tax bracket. Paying taxes on a large gain is not the worst problem to have, and your child would still likely be eternally grateful for the investment decisions you made back in 1980; HOWEVER, if instead of simply holding Apple shares for the duration, you could have used tax planning strategies to reduce the overall tax burden. In this case, engaging in a strategy of “tax-gain harvesting” may have been advisable.

For example, if you were to have strategically sold and then repurchased small amounts of Apple shares during the time period the tax liability may have been avoided or could have been very small due to the child’s low tax bracket. Based on annual income, federal capital gains tax rates can vary between a 0%, 15%, or 20% tax rate. Slowly selling and repurchasing small amounts of Apple could have taken advantage of a smaller capital gains tax rate (potentially a 0% rate compared to 15%, or 15% vs 20%). Then the repurchase of the shares would have increased the child’s overall cost basis, essentially “resetting” their cost basis to the current share price. This process is called “tax-gain harvesting.”

In this example it could have been possible to sell the shares of Apple periodically to trigger the capital gain and then repurchase the share(s) to reset the cost basis while potentially avoiding taxes if done in a strategic manner.

While many people take a “set it and forget it” approach when investing for minors, a more active investment and tax strategy may create long-term benefits. When in doubt it is best to work with your financial advisor as they can look at your cost basis and your income/federal tax bracket to determine how many assets to sell/repurchase.