Four reasons to convert a custodial account to a 529 plan

Bill Cass, CFP®, CPWA®

Bill Cass, CFP®, CPWA®, 05/14/19

Four reasons to convert a custodial account to a 529 plan

Before 529 college savings plans became a popular way to fund a college education, many families utilized traditional custodial accounts (UTMA or UGMA). As 529 plans evolved, the definition of qualified expenses expanded, making these accounts more competitive with other savings vehicles.

Tax treatment and custodial accounts

A primary benefit of custodial accounts is that (up to certain limits) any income generated is not taxed or only taxed at the child’s tax rate instead of a higher tax rate. In the past, once the child’s unearned income exceeded a certain amount, the additional income would be taxed at the parent’s (higher) tax rate. Under the Tax Cuts and Jobs Act (TCJA), this excess amount is no longer taxed at the parent’s tax rate. Instead, the additional unearned income is taxed at trust tax rates.

For 2019, here is how the kiddie tax is calculated:

  • First $1,100 of unearned income — no tax
  • Next $1,100 of unearned income — taxed at child’s tax rate
  • Unearned income over $2,200 — taxed at trust tax rates
For more detail on 2019 tax rates including tax brackets for trusts see the Wealth Management Center's blog, "Key tax figures for 2019."

The kiddie tax applies to children under the age of 18. Once the child reaches 18, the tax continues to apply unless the child’s earned income represents more than one half of support needs. It also applies at ages 19 to 23 if the individual is a full-time student and relies on parents for at least one half of support needs. The tax would not apply if the child is not considered a dependent of the parents.

The kiddie tax was expanded a few years ago from 17 and under to 18 and under, and from ages 19 to 23 for students. Prior to these changes, the kiddie tax had less impact.

Considering the broader tax benefits, 529 programs may be a more tax-efficient way to save for college.

Advantages of funding a 529 account

Some parents may decide to liquidate their UTMA or UGMA accounts and use the assets to fund a 529 college savings plan.

There are several reasons to consider this strategy: 1. Tax benefits: 529 plans offer tax-free growth and tax-free withdrawals if funds are used for qualified education expenses. Qualified expenses include, but are not limited to, tuition and room and board at any accredited college. Up to $10,000 annually (per student) may be used for K–12 tuition. (There may be adverse tax consequences imposed by certain states.)

2. Financial aid: According to current federal guidelines, 20% of assets in a custodial account are considered when determining a child’s eligibility for aid under the Free Application for Federal Student Aid (FAFSA), compared with generally only 5.6% of 529 assets. Custodial assets are treated as assets of the student, while 529 assets are considered assets of the account holder, which is usually the parent. Also, grandparent-owned 529s are not currently included as part of the asset test calculation for determining financial aid, but may be included in the income test portion of the FAFSA calculation. For more details on how college savings accounts may impact financial aid, read "Understanding the paths to securing college financial aid."

3. Investment options: UTMA and UGMA accounts do not generally include an age-based investment option, which has become a hallmark of the 529 plan. An age-based investment option adjusts its allocation automatically over time, placing a greater emphasis on preserving assets as a child gets closer to starting college.

4. Tax advantaged gifting: A special provision of 529 plans allows contributions equal to five years’ worth of gifts to a single beneficiary in a single year without triggering the federal gift tax. For 2019, the gifting limit is $15,000 annually for individuals and $30,000 for married couples. The five-year feature means that an individual could gift $75,000 into a 529 in a year, effectively front-loading five years’ worth of gifts.

Considerations before converting UGMA/UTMA assets to a 529

  • Since a gift into an UGMA/UTMA is irrevocable, the custodian must utilize those funds solely for the benefit of that child. In fact, once the beneficiary reaches the age of majority they automatically become the owner of the account. In contrast, parents who contribute funds directly to a 529 have the flexibility to change the beneficiary of the 529 account. Because of these rules, former UGMA/UTMA assets transferred to a 529 must be kept separately from other 529 assets, since the beneficiary on that portion cannot be changed.
  • While 529 plans offer key tax benefits, funds must be used for qualified education expenses. Parents may want to retain some funds in an UGMA/UTMA to cover other expenses such as transportation, which is not currently considered a qualified expense for 529 plans.
  • Converting funds from an UGMA/UTMA to a 529 requires liquidating those assets to fund the 529 with cash. Parents will want to review the potential tax consequences of liquidating UGMA/UTMA assets.
Traditionally, parents had limited vehicles to save for college. But since their introduction more than 20 years ago, 529 plans have evolved into a competitive offering. In 2018, 529 plan assets totaled $328.9 billion in 13.6 million accounts (College Savings Plans Network).

Families may want to seek guidance from a professional financial advisor to set education savings goals and identify investment choices. College costs have risen dramatically in the last decade, making it important for families to make the most of college savings.

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