This week, Gail explains the rationale behind switching the content of a custodian account into a 529 college savings plan -- something many parents have to think of as their child approaches college age.
My children are 13 and 16. Much of their college savings came from their grandparents and was saved in UGMA accounts (I am the custodian). At the time it seemed like a good way to keep the funds earmarked for college, and separate from family funds. Of course, over the years they have been paying income taxes on the income from these funds (mostly at my tax rate).
Does the UGMA custodian have the right to essentially "raid" a child's UGMA account and fund a 529 with the proceeds? Beyond the capital gains taxes that may be due for selling assets in the UGMA account, are there any other considerations?
These are the benefits I see in moving the funds from UGMA to 529 accounts:
- It gets the funds out of the child's eventual control and "dedicated" rather than just "intended" for college.
- The child would stop paying income taxes on the gains
- 529's seem better than UGMA accounts as a place for future "gift" funds from parents or grandparents.
And there are a few negatives:
- There may be funds left in the 529 after all children are finished with college, and there are restrictions/penalties on the use of this money.
- It might not be worth the hassle for a child only 1 year away from starting college.
Well, you've certainly done your homework! But I need to correct a couple of misconceptions:
1) 529s do not require that withdrawals be used for college, and
2) investing UGMA assets into a 529 does not eliminate the UGMA.
First, a little background. "UGMA" stands for Uniform Gift to Minor Account. In some states, a similar account is called an "UTMA" for Uniform Transfer to Minor Account. Both were created because an individual cannot legally own financial assets until he/she has reached what is considered the "age of majority."
To solve the problem, assets given to an individual who is under this age can be placed in an UGMA/UTMA account, which is managed on the minor's behalf by an adult custodian. (For the sake of simplicity, I'll only refer to a "UGMA" from here on, however the same rules apply to an UTMA.)
The custodian of the UGMA, by law, can only use the assets for the minor's benefit. But there is considerable latitude in this regard. Essentially, if you, as the custodian of your children's UGMA, believe that moving the money into a 529 plan is in the minor's best interest, then you may do so.
By federal law, contributions to a 529 plan can only be made in cash. So as you point out, this necessitates selling the assets currently in the UGMA. If a profit is realized, there will be capital gains tax due. Once you have the proceeds from the current UGMA investments, you can invest the money in a 529 account with that child named as beneficiary.
However, you are incorrect in believing that moving the assets from an UGMA to a 529 will remove them from the child's control. No one -- not even the custodian -- has the power to cancel the UGMA, which is an irrevocable trust created on behalf of that child. So the UGMA will actually be the "owner" of the 529 account. (Perhaps an easier way to think of this is that the UGMA remains in force; all you are doing is changing what the trust is invested in.) You, as custodian of the UGMA, retain the power to decide how the money will be invested among the various choices in the 529 plan until the beneficiary of the UGMA reaches the age of "majority" in your state (generally age 18 or 21).
At that point, the UGMA is essentially dissolved and the beneficiary now becomes the owner. At this point he can do whatever he wants with the money, just as he could if the UGMA were invested in mutual funds or stocks or a bank account.
The difference is, if money withdrawn from a 529 is used for things other than college expenses, the owner will owe ordinary income taxes and a 10% penalty. So, unlike a plain UGMA, there is an disincentive that can discourage the child from withdrawing the money and running off to Europe. (Oh, I know, your Suzie wouldn't dream of doing that, but just in case....)
In addition, money invested in a 529 plan has the potential to grow tax-deferred. This would eliminate the tax your children have to pay on their college accounts each year. In addition to avoiding annual taxation, provided the assets are used for "qualified expenses" such as tuition, room and board, books, fees or supplies, there is no capital gains tax due on any profits from a 529 account when they are eventually withdrawn.
Even if your child is close to starting college, switching the investments in the UGMA to a 529 can make a lot of sense. He's going to have to pay capital gains tax eventually, anyway. And if the UGMA's investments are worth less now because the stock market is lower, this means his tax bill will be less.
Don't forget, depending upon how much is in the UGMA/529, the assets in it could last for four years worth of college or even beyond that to graduate school. That's at least four additional years where he won't have to pay tax on the UGMA's income.
You don't have to liquidate the entire UGMA in order to invest in the 529. If your child will need a car when she starts college, consider leaving enough money in the UGMA's existing investments to cover this expense. That way you can withdraw the money without a penalty. (No matter how far you have to drive to get to campus, transportation expenses are never considered a "qualified" use of 529 money.) Invest the non-car money in the 529 plan.
Obviously, the older the beneficiary of a 529, the more conservative you want to be in investing the money. A number of 529 plans offer what is called a "stable value" fund, where the principal has very little fluctuation. There might also be a "conservative" investment choice or one which is "age-weighted," with a greater portion of the money shifted into in money market instruments as the child ages. Of course, the trade-off is that you get a lower return in exchange for this very low risk. But if the beneficiary is a 16-year old, you really don't want to risk any principal.
You can afford to get a little more opportunistic about investing your 13-year-old's money. But I'd still play it cautious and err on the conservative side. Consider dividing the money among large-capitalization stocks, bonds, and cash if your 529 provides these choices. Or look at a plan that offers investments which are automatically re-balanced so your portfolio doesn't take on more risk than you originally planned.
If there is money left in his 529 after a child graduates from college, it does not need to be spent before he reaches a specific age. He can essentially leave the money in the 529 until, say, he decides to go to grad school. Or, if he has a child of his own, he can change the beneficiary from himself to his child. (There are potential gift taxes involved in this, so consult a tax professional before making this move.)
If your daughter wanted to use the leftover money in her 529 to take a vacation or buy a house, she could certainly do this. But since neither is a "qualified" college expense, ordinary income tax and the 10% penalty would be assessed. However, these would only apply to the gain, not the entire amount.
A word of caution: Any additional contributions made to the UGMA/529 will become the property of the child once he reaches majority age. So if you, your wife, or the grandparents want to add to his college fund, I suggest opening a second, non-UGMA 529 plan. Assets in this account will never become the property of the beneficiary, no matter how old he is, unless you want to transfer ownership to him.
As regular readers of this column know, I am a huge fan of 529 plans. They make a lot of sense for parents and children alike. Hope this helps!
Dear Ms. Buckner,
Do you know of any state 529 plans which allows a trust to be the creator of a 529 account?
I am the trustee of a trust set up by my late father for his grandson, my nephew. The conditions of the trust is that the money is to be used for his higher education and then when he is 25 he is to receive the balance.
Because this is considered a "complex trust," taxes and tax preparation fees are eating the trust alive. My accountant suggested that I should look into a 529 account, but all the information I can find assumes that one is either a parent or grandparent. Do you have any suggestions on ways in which I can protect the trust from these costly taxes and fees?
Dear Jacqueline -
Let me answer your first question this way: I know of no 529 which does NOT allow a trust to be the owner of the account. In fact, it's a brilliant idea!
As you probably know, a trust is subject to the same income tax rates as a person. However, a trust falls into the top income tax bracket of 38.6% at a much lower income level (in the neighborhood of $9,000). Investing the trust's assets in a 529 plan immediately STOPS any further taxation of those assets provided they're used for college-related expenses. (See the answer above.)
To accomplish this, you simply instruct the trustee to invest the trust's assets in the 529 college savings plan of your choice. The trust would be listed as the "owner" of the 529. The beneficiary of the trust -- your nephew -- would be named as the beneficiary of the 529. At age 25, the trust could transfer ownership, and thus, control, of the 529 to him.
If you can't find a 529 sponsor able to accommodate this, get in touch with a financial advisor or search the internet. A good starting point is the website www.savingforcollege.com.
Your nephew has a smart aunt!
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