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Converting UGMA/UTMA to 529 -- good idea or bad?
Your clients set up an UGMA or UTMA account for their child several years ago and have been gifting cash and securities into the account. Should they now convert the account to a 529 plan?
The likely answer is "not yet." Here are three reasons why it might not make financial sense to convert the UGMA/UTMA to a 529 until the child is older and financial-aid eligibility becomes an issue.
First, the existing UGMA/UTMA is probably already very tax-efficient, and the extra tax benefits of a 529 plan may not add up to much.
The child's first $1,000 of taxable investment income is completely sheltered by the standard deduction. And the next $1,000 of investment income is taxed at 10 percent if it consists of interest income, short-term capital gains and non-qualified dividends—and zero percent if it consists of qualified dividends and long-term capital gains.
The "kiddie tax" only kicks in once the child's investments and other sources of unearned income produce more than $2,000 in annual income. It takes a rather sizable UGMA/UTMA to generate that much taxable income each year. Also, consider that the kiddie-tax income threshold adjusts periodically for inflation.
Secondly, all of the untaxed gains in the existing UGMA/UTMA will be triggered as capital gains if converted to a 529 plan. Contributions to a 529 plan must be made in cash.
The bunching of capital gains in the year of conversion makes kiddie-tax problems much more likely. And if the kiddie tax applies, instead of being taxed at zero percent, capital gains are subject to the parents' capital gains tax rate (likely 15 percent).
By not converting, gains in the existing UGMA/UTMA can be carefully managed over several years to minimize or avoid the kiddie tax and take full advantage of the zero-percent capital gains bracket.
Thirdly, most 529 plans charge a management fee. While 529 fees have come down dramatically over the years, it is still an extra cost that works against the decision to convert.
Of course, our analysis assumes the exact same investments are used in the existing UGMA/UTMA and in the 529 plan. This rarely turns out to be the case. In fact, the investments offered by a 529 plan may be better quality and/or lower cost than what the client's UGMA/UTMA is currently invested in. The 529 plan may also offer a beneficial investment strategy—the age-based option—that is difficult to replicate outside of a 529 plan.
Financial-aid eligibility is the wild card that favors moving the UGMA/UTMA assets into a 529 plan. Outside of the 529, those assets are reported as student assets that add significantly (20 percent of value) to expected family contribution (EFC). But moving those assets into a 529 plan allows them to be reported as parent assets, which are assessed at 5.6% or less in determining EFC.
The financial-aid advantage to conversion is available any time up to the day before filing the FAFSA aid application. Just be careful to time the conversion so that the triggering of capital gains does not work against financial-aid eligibility.
Savingforcollege.com is pleased to announce our newest online calculator; the UGMA/UTMA 529 Conversion Calculator. This free tool is easy to use and displays the results in graph and table formats. We invite you to give it a whirl.