Financial Planning Blog

Did you set up a custodial account to save for college expenses when your child was young? Have you ever wondered if it made sense, or was even possible, to move those assets into 529 plan? Well, it is possible, and it may make sense for you to make the effort, depending on your situation.

First, some background on Section 529 plans and custodial (UGMA/UTMA) accounts.

Section 529 plans, such as the Idaho College Savings Program (IDeal) are today's preferred education savings vehicle. These plans, which started becoming available in the late 90's, enable parents (and grandparents or other interested parties) to save considerable amounts for their children's higher education expenses, with investments growing tax-deferred until they are distributed tax-free for qualified educational expenditures. They are simple to set up and there are plenty of good (and bad) plans to choose from. To top it off, many states (including Idaho) offer generous state tax incentives to utilize the home state plan.

Prior to the arrival of 529 plans, UGMA (Uniform Gift to Minors Act) and UTMA (Uniform Trust for Minors Act) custodial accounts were the most popular method for tax-favored college savings. These custodial accounts are used to hold and protect assets for a minor until they reach the age of majority. (In Idaho this is age 18 for UGMA accounts and age 21 for UTMA accounts.) When using a custodial account to save for college, the investment earnings within the account are taxed to the minor, not the parent/custodian. In 2009, youth can make up to $1,900 in unearned income (e.g. investment income in their custodial account), paying nothing on the first $950, and only 10% federal income taxes on the next $950. Above $1,900 in unearned income, the investment earnings are taxed at the parents' higher marginal tax rate--the so-called "kiddie tax". (The "kiddie tax" used to only apply kids age 14 and under. In 2006 the age was raised to 18. In 2008 it was broadened further to include students, age 19-23, who earn less than half his or her individual support.)

Although custodial accounts provide potential tax advantages to families saving for college, there are a few key disadvantages.

• Once the money is put into the custodial account, it is the child's money. The parent acts as a custodian, taking care of the assets for the benefit of the child. The parent cannot choose to move any of the assets to another child. This is unlike a 529 plan, where the parent is generally owner of the account, and can change beneficiaries of the account if they desire.
• When the child reaches the age of majority, they gain control of the account. They can choose to use the money for purposes other than college, even if their parents had intended the investments only for that purpose. This loss of control is major concern to some parents--although they should have been aware of the issue when they funded the account. (Apparently what isn't a concern when the child is a cute, little toddler, can become a major worry when they meet the teenager.)
• When determining the expected family contribution (EFC) for financial aid purposes, a custodial account is considered an asset of the student and assessed at a higher rate (20%) than parental investment accounts (including 529 plans) which are assessed at a maximum of 5.64%. (See this article at SavingforCollege.com.) As a result, the same funds held in a custodial account will have almost a four times larger impact on the EFC, potentially lowering the amount of financial aid offered to the student.

As you will see in Part 2, transferring a custodial account into 529 plan is a viable strategy to deal with this last issue (the impact on EFC), but is little help in allowing parents to regain control of the funds they placed in custodial accounts.