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COLLEGE SAVINGS 101

Should you open an UGMA/UTMA 529?
http://www.savingforcollege.com/articles/should-you-open-an-ugmautma-529?page=1

Posted: 2008-02-15

by Joseph Hurley

What is an UGMA/UTMA 529?

It refers to account in a 529 plan funded with money already owned by your minor child. Because minors generally cannot directly own an investment or bank account, an adult custodian must manage and use the funds for the benefit of the minor child as prescribed under the state's Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA). Another name frequently used for a 529 account opened with UGMA/UTMA money is "custodial 529 account."

Nearly all 529 savings plans have special procedures to accommodate UGMA/UTMA 529s. For example, the plan administrator will not permit changes in the beneficiary designation prior to the current beneficiary's 18th or 21st birthday (depending on the state). And when the current beneficiary reaches the age of legal ownership, he or she will have the right to contact the 529 plan administrator and take direct ownership and control of the 529 account.

I'd like to put my son's UTMA money into a 529 plan without telling the plan where the money is coming from. That way my son will still be the beneficiary, but I'll be the owner and can control the account without worrying about what happens when my son turns 18. Is there anything wrong with this approach?

Establishing the 529 account in your own name as owner does not change the custodian's legal obligation under the UTMA to use the funds for the benefit of that particular child. If you were to change the beneficiary and use the 529 money for a different child, or deny your son's right to take direct ownership at the age of 18 (if that is the legal age in your state), you are probably in violation of the UTMA. An attorney can help explain this to you.

If you are worried about your son making poor decisions because of this money, you might better look for ways to "spend down" the account while he is still a minor. If you were to use the UGMA/UTMA account to pay for expenses incurred for his benefit, instead of paying for those expenses yourself, you will have more money to fund a 529 account under your own ownership.

I've heard that UGMA/UTMA 529s have been granted favored status under the financial aid laws? Is this true?

Yes, it is true. Beginning with the 2006-07 school year—but ending with the 2008-09 school year—your child's UGMA/UTMA 529 does not have to be reported on the federal financial aid application (FAFSA). The same exception applies if the UGMA/UTMA has terminated and your child (the student) owns the 529 account directly. But note: this special rule applies only if your child files the FAFSA as your dependent, which is the case for the vast majority of undergraduates.

The treatment of an UGMA/UTMA 529 changes beginning with the 2009-10 school year, but is still beneficial. The account is reportable on the FAFSA, but not as a student asset assessed at the usual 20% student rate. Instead, it is reported as a parental asset at the lower 5.64% maximum parental rate. The fact that an asset owned by one party (in this case the student) is treated as if it is owned by another (the parents) is highly unusual in the financial aid laws.

Do we improve our child's financial-aid prospects by moving his existing UGMA/UTMA investments into an UGMA/UTMA 529?

Quite possibly yes. Let's assume your child's UGMA/UTMA account has $50,000 worth of mutual funds on the day he or she files the FAFSA. Your Expected Family Contribution (EFC) will include 20% of that value, or $10,000. If the mutual funds were liquidated and the cash contributed to an UGMA/UTMA 529 prior to submitting the FAFSA, your EFC will include at most 5.64% of that value, or $2,820. Your child's "financial need" increases by at least $7,180 for the current school year.

But there are some important caveats. You have to consider the consequences of liquidating the mutual funds and triggering capital gains. Any gains will not only be reportable on your child's income tax returns, but they will also be included in base-year income on the following year's FAFSA, which can cause a decrease in aid eligibility.

Also remember that we are talking here only about federal financial aid. For school-based aid (grants, scholarships, or tuition discounts from the school's own funds), you are not likely to find the same advantage by moving UGMA/UTMA money into a 529 plan.

How about making contributions of my own money to my child's UGMA/UTMA 529? Will that help?

No. Beginning with the 2009-10 school year, a 529 account is treated as your parental asset whether owned by you, by your child through an UGMA/UTMA, or by your child directly. Most parents would prefer to retain control by contributing to their own 529 accounts.

But what about the 529 plans I have for my younger children? Will I have to report them on my older child's FAFSA?

Great question. The federal government is telling us that you must include as parental assets the 529 accounts you own for anyone else, because you have full ownership and control of those accounts. It's unfortunate when the funds set aside for a younger child's college education negatively impact the financial-aid eligibility of the older child trying to pay for college.

In this case, you may want to seriously consider setting up the 529 accounts for your younger children as UGMA/UTMA 529s, recognizing the additional restrictions and ultimate loss of control. If you have already established the accounts as parent-owned 529s, you may find that your 529 plan administrator will not accept your request for a change in ownership. Avoid taking any action that will be treated as a liquidation of your existing 529 account, leading to tax and penalty on the growth.

Okay, let's forget about financial aid for a moment. Is there an income tax savings from moving my child's UGMA/UTMA money into an UGMA/UTMA 529?

There could be substantial tax savings, assuming your child would otherwise be paying income tax on taxable interest, dividends, or capital gains. The 529 account will grow tax-deferred, and come out tax-free to pay for college.

But wait, it's not quite that simple. Your dependent child can report as much as $950 in investment income in 2009 without being subject to federal income tax. If your college savings never threw off more than $950 in annual income, you might be better off keeping the UGMA/UTMA invested in mutual funds and other taxable investments. (A 529 plan has the disadvantage of a small layer of additional fees, as well as the risk of future tax and penalty if the 529 account is used for something other than college.)

You also have to consider the tax consequences of moving the money from the taxable investment into the 529 plan. Triggering any gains this year may cost more in taxes when compared to spreading out the gains over a number of years.

If the existing UGMA/UTMA taxable investments are throwing off more than $950 in annual income, the analysis turns in favor of the 529 option. Although the income between $950 and $1,900 remains taxable at the child's low tax bracket, if it rises above that level it may become taxable at the parents' marginal tax bracket. This rate bump is known as the "Kiddie Tax" and beginning in 2008 it applies to the following three groups of taxpayers: (1) children through the age of 17; (2) 18-year olds who do not earn more than one-half of their own support; and (3) 19- to 23-year-old full-time college students who do not earn more than one-half of their own support.

Because of the control issues, the Kiddie Tax, and the financial-aid consequences, most families looking to invest substantial dollars for college should be looking toward 529 plans and away from UGMA/UTMA accounts.

Joe Hurley is the founder of Savingforcollege.com LLC, and a certified public accountant.

What is an UGMA/UTMA 529?

It refers to account in a 529 plan funded with money already owned by your minor child. Because minors generally cannot directly own an investment or bank account, an adult custodian must manage and use the funds for the benefit of the minor child as prescribed under the state's Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA). Another name frequently used for a 529 account opened with UGMA/UTMA money is "custodial 529 account."

Nearly all 529 savings plans have special procedures to accommodate UGMA/UTMA 529s. For example, the plan administrator will not permit changes in the beneficiary designation prior to the current beneficiary's 18th or 21st birthday (depending on the state). And when the current beneficiary reaches the age of legal ownership, he or she will have the right to contact the 529 plan administrator and take direct ownership and control of the 529 account.

I'd like to put my son's UTMA money into a 529 plan without telling the plan where the money is coming from. That way my son will still be the beneficiary, but I'll be the owner and can control the account without worrying about what happens when my son turns 18. Is there anything wrong with this approach?

Establishing the 529 account in your own name as owner does not change the custodian's legal obligation under the UTMA to use the funds for the benefit of that particular child. If you were to change the beneficiary and use the 529 money for a different child, or deny your son's right to take direct ownership at the age of 18 (if that is the legal age in your state), you are probably in violation of the UTMA. An attorney can help explain this to you.

If you are worried about your son making poor decisions because of this money, you might better look for ways to "spend down" the account while he is still a minor. If you were to use the UGMA/UTMA account to pay for expenses incurred for his benefit, instead of paying for those expenses yourself, you will have more money to fund a 529 account under your own ownership.

I've heard that UGMA/UTMA 529s have been granted favored status under the financial aid laws? Is this true?

Yes, it is true. Beginning with the 2006-07 school year—but ending with the 2008-09 school year—your child's UGMA/UTMA 529 does not have to be reported on the federal financial aid application (FAFSA). The same exception applies if the UGMA/UTMA has terminated and your child (the student) owns the 529 account directly. But note: this special rule applies only if your child files the FAFSA as your dependent, which is the case for the vast majority of undergraduates.

The treatment of an UGMA/UTMA 529 changes beginning with the 2009-10 school year, but is still beneficial. The account is reportable on the FAFSA, but not as a student asset assessed at the usual 20% student rate. Instead, it is reported as a parental asset at the lower 5.64% maximum parental rate. The fact that an asset owned by one party (in this case the student) is treated as if it is owned by another (the parents) is highly unusual in the financial aid laws.

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