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Will I Need to File a Tax Return on a Uniform Transfer to Minor Account?

Howard Hook, CFP®, CPA, quoted in The Star-Ledger's business/finance column, "Biz Brain" on November 20, 2012

Question:  I have a New Jersey tax-free bond fund that I have invested for my young grandson. It's in a Uniform Transfers to Minors Account (UTMA). If at one point the fund generates a tax-free income of over $950, would I be obligated to file a tax return for him?

Answer: Your grandson is lucky to have you thinking of his future college costs – and of tax burdens, too. Municipal bond income is generally tax-free for federal income tax purposes, no matter how much is earned. A New Jersey bond fund would also be free for New Jersey state tax, said Howard Hook, a certified financial planner and certified public accountant with EKS Associates in Princeton, “There are special rules regarding the income taxation of unearned income such as interest and dividends for children under age 24 and a full time student, or under age 19.” Hook said. “The first $950 of unearned income is not taxable. The next $950 is taxed at the child's rate with the amount greater than $1,900 taxed at their parent's marginal rate.”

But in your case, because the income is tax-free, none of that would come into play, he said.

But, a tax document is generated showing the tax-free income. If the income is greater than $950, the child should file a return showing the tax-free income on the return, Hook said. But no tax would be due. “Filing the return would be helpful because it would prevent the IRS from sending a tax notice asking why a return had not been filed,” Hook said.

There is one caveat, though. Municipal bond mutual funds, unlike individual bonds, can have a taxable component to them, Hook said.

“Bond funds typically sell bonds during the year. Any gain on the sale of the bonds inside the bond funds is taxable to the shareholders of the bond mutual fund, even though the interest generated by the bond fund is tax-free,” he said. In your case, as long as the amount of taxable income is not greater than $1,900, the taxable portion of any bond fund distributions would be taxed at the child's rate, he said.

You may want to consider a 529 Plan instead, depending on your grandson's age, said Vince Pallitto, a certified financial planner and certified public accountant with Summit Asset Management in Florham Park. “I am not sure what the duration and yield on his municipal bonds are, but they could lose money if and when interest rates rise,” he said. “Depending on his grandson's age, he could invest for higher yielding market returns, and buy and sell investments (within the 529 Plan) without generating a tax liability. They would always be tax-free if used for college expenses.”