UGMA/UTMA conversions to 529: When do they make sense?

http://www.savingforcollege.com/articles/ugma-utma-conversions-to-529

Financial Professional Content

Many parents have established an UGMA/UTMA custodial account as a funding vehicle for a child's future educational expenses. Oftentimes, these accounts have significant investment balances. Should an existing UGMA/UTMA be converted to a 529 plan? The answer will usually depend on whether or not the child is exposed to the insidious "kiddie tax." Here are the rules of thumb that will make it easier to make the proper decision.

The kiddie tax refers to the set of federal tax rules that applies the parent's marginal tax rate to the unearned income above $2,000 reported by a child under 19 or a full-time college student under 24. Carve-outs from the kiddie tax apply to certain children who can show enough earned income to be self-supportive.

Even when subject to the kiddie tax, the child's first $1,000 of unearned income is sheltered completely by the standard deduction, and the next $1,000 of unearned income is taxed at the child's own tax bracket (10 percent for ordinary income and 0 percent for long-term capital gains).

Rule-of-thumb 1: If you know the child is subject to the kiddie tax in 2013, and will be in future years, seriously consider a conversion to a 529.

Explanation: Some portion of the child's investment income is currently being taxed at a high rate—i.e. the parents' rate—and so the tax savings potential of a 529 plan becomes compelling. Because only cash contributions may be made to a 529 plan, the conversion will trigger capital gains on any built-up appreciation in the UGMA/UTMA, and those gains will be subject to the kiddie tax as well. But you might decide the capital gains are going to be triggered at some point anyway, either when the account is spent down or when its investments are reallocated, and it simply becomes a matter of this year versus a future year. If the built-up gains in the UGMA/UTMA are so large as to cause a tax or financial-aid detriment if triggered all at once, reconsider the conversion strategy.

Rule-of-thumb 2: If you know the child will NEVER have enough unearned income to be subject to the kiddie tax, hold off on the conversion.

Explanation: The child is already in a very favorable tax situation with the existing UGMA/UTMA, and little, if any, advantage can be gained by using a 529 plan. This is especially true if a conversion to a 529 would trigger the kiddie tax because of capital gains. Remember, even if the account is appreciating so much that the liquidation of the UGMA/UTMA might cause a kiddie tax problem in the future, the custodian can take steps each year to "release" part of the gain (keeping total unearned income below $2,000) and reduce or eliminate that future problem.

Let's assume you expect a 5 percent total annualized return in the UGMA/UTMA. An account balance below $40,000 ($2,000 divided by 5%) can probably be managed to stay below the kiddie tax threshold. However, consider the effect of compounding on future account balances.

Rule-of-thumb 3: If the child is not currently subject to the kiddie tax, but would be if all appreciation in the UGMA/UTMA were recognized each year for taxes, a projection exercise may be necessary.

Explanation: Unfortunately, the projection will not be easy to do with any level of precision. For one thing, the kiddie tax threshold increases each year with inflation, and so only the account appreciation in excess of the inflation rate will benefit from the tax sheltering of a 529 plan. For another, the timing of the gains recognition might be managed to lower the future exposure to the kiddie tax. If you are lucky, a modest effort to project the future will steer you toward one of the first two rules of thumb.

Rule-of-thumb 4: If the child is in the process of applying for financial aid, most likely make the conversion.

Explanation: Converting a non-529 UGMA/UTMA to a 529 UGMA/UTMA immediately boosts a student’s financial-aid eligibility by recharacterizing the asset from a student asset (included in Expected Family Contribution at 20% of value) to a parent asset (included in EFC at 5.64% or less of value). There is no particular logic in this rule—it is simply what the law says as a way to remove disincentives for college savings. This conclusion assumes, of course, that you will be liquidating the account and recognizing capital gains anyway, in order to pay for college.