MORE FLEXIBILITY FOR HELPING GRANDKIDS WITH COLLEGE

 

Transferring a custodial account set up under the Uniform Gift to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) to a section 529 college savings plan can potentially result in a number of tax advantages.

UGMA/UTMA accounts are set up for the benefit of a minor. Anyone can contribute to the account, and the custodian (such as the parent or grandparent) retains control of the account until the minor reaches the age of majority. At that time, control passes to the child, and assets in the account can be withdrawn for any purpose. However, earnings on the account are taxed at the child’s rate (see below).

Taxes for unearned income in UGMA and UTMA accounts (2010 figures)


Child’s age

Income

Federal tax rate

Under 18 years

$0–$950

0%

$950–$1,900

Child’s tax rate (usually 10% after deductions related to investment income)

More than $1,900

Parent’s marginal tax rate

18 or older

$0–$950

0%

 

More than $950

Child’s tax rate (usually 10% after deductions related to investment income)

IRS Publication 929

Now, thanks to the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), there may be a better option for investors saving for a child’s college education: section 529 plans, which are state-sponsored college savings plans.

It’s easy to fund most 529 plans with assets from an UGMA/UTMA account. The minor is named as the beneficiary of the 529 plan, and the UGMA/UTMA custodian is considered the owner of the 529 plan until the child reaches the age of majority.

There are some disadvantages to such a transfer. First, investments to a section 529 plan must be made in cash. That means any assets in the UGMA/UTMA account must be sold before you transfer the assets to a 529 account. And if those assets have grown in value, the sale will result in gain that’s taxable on the child’s tax return.

These disadvantages, however, may be outweighed by the tax benefits of such a transfer. After the transfer, the earnings in the section 529 plan can potentially grow tax-free. That’s an advantage if the earnings in the custodial account were large enough to result in tax on the minor. In 2010, the first $950 in income from a minor’s investment is free of federal income tax, and the next $950 is taxed at the lower child’s rate (in 2010, typically 0% for dividends and capital gains, and no more than 15% for interest). But investment income over $1,900 is subject to the parents’ tax rate, which is usually higher.

Earnings in the section 529 plan will then be tax-free when withdrawn, provided that the money is used for qualifying higher education expenses. If money is used for other purposes, however, the earnings will be taxable and generally subject to a 10% penalty tax as well.

Finally, remember that as with any investment, section 529 plans offer no guaranteed rate of return. Moreover, out-of-state section 529 plans may have in-state income tax ramifications. Always ask for and carefully read a plan’s program description for complete information, including risks, fees and expenses.

 

We can help you develop a strategy to help achieve your long-term funding goals. Contact our office to find out how transferring assets from an UGMA/UTMA account to a section 529 plan can benefit you.

 

This article is not intended to provide tax or legal advice and should not be relied upon as such. It is a summary of our understanding and interpretation of some of the current laws and regulations and is not exhaustive. Investors should consult their legal or tax advisor for advice and information concerning their particular circumstances.