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COLLEGE SAVINGS 101

UTMA accounts for college

posted: 2013-08-15

by Joseph Hurley

UTMA accounts for college

Can a custodial UTMA account for your child be a tax-efficient way to save for college? Will it involve lower fees and offer more investment options than a 529 plan?

The answer to those questions is "yes", but not without some huge caveats that have to do with the kiddie tax, financial-aid eligibility, gift-tax forms, and reckless spending. Here's the scoop.

Long before 529 plans came along in the 1990s, parents and grandparents were gifting cash and securities to their minor children and grandchildren using the Uniform Gifts to Minors Act (UGMA). One reason for their popularity was because UGMAs were easy to establish at banks and other financial institutions. The other reason had to do with taxes: investment income generated by an UGMA account was reported on the child's income tax returns, and most children were in low or zero tax brackets.

UGMAs are still around, although just about every state has shifted to a new and similar law called the Uniform Transfers to Minors Act (UTMA).

In 1986, Congress' displeasure with parents using their children as tax shelters led to the so-called "kiddie tax," a mechanism that subjects a child's investment income above a threshold to the parent's marginal tax rate. Since enacting the kiddie tax, much of the tax-sheltering potential that comes with having kids has disappeared.

For 2013, the kiddie tax kicks in at $2,000 of unearned (e.g. investment) income. The first $1,000 is tax-free, covered by the child's standard deduction. The next $1,000 is subject to the child's tax rate, which starts at only 10% for ordinary income, and 0% for long-term capital gains. As you can see, below the $2,000 income threshold a tax-saving opportunity still exists.

Let's assume you decide to invest in Treasury bonds yielding 3 percent interest for your child's college education. You and your spouse each gift $14,000 this year (the most you can give without filing gift tax forms) to your child's UTMA account for the purchase of the bonds.

The $840 in annual interest received from the bonds is free from federal income tax, thanks to your child's $1,000 standard deduction and no kiddie tax. You don't incur management fees like you would in most 529 plans, and if the UTMA investment is eventually used for something other than college you don't face taxes and a 10 percent penalty on distributed earnings, like you probably would with a 529 plan. The UTMA looks like a pretty good alternative to a 529 plan.

But what happens if you prefer to put the UTMA account into growth stocks or index funds under a buy-and-hold approach? Assume the investments appreciate at 4 percent annually, and that in five years you will liquidate the UTMA to pay for college. (To make things simple, we will disregard the effect of compounding and the future inflation adjustments to the kiddie-tax income threshold.)

For the liquidation year, your child will have a $5,600 long-term capital gain to report on his or her tax return, which is well above the kiddie tax income threshold. At least $3,600 of that gain will be taxed at your capital gains rate, not the child's. (And don't for a moment believe that your child escaped from kiddie-tax jail at the age of 14. That rule is long gone. The kiddie tax now applies to most college students as old as 23.)

You may well be better off having invested in a 529 plan so that investment earnings remain totally tax-free, provided the child spends enough for college. The state tax breaks for a 529 plan can boost its advantage even further.

Next consider the financial-aid disadvantage with UTMA accounts. Student-owned investments (including UTMA accounts) are assessed at a 20% rate in determining Expected Family Contribution (EFC). The investment earnings also contribute to student income, which above a certain allowance is subject to a 50% assessment rate in determining EFC.

Parent-owned assets are subject to a much-lower 5.64% assessment rate in the EFC formula. A special provision in the financial-aid law treats a 529 plan owned by either the parent or the student as a parent asset, not a student asset. The 529 account also has the huge advantage of throwing off tax-free income when used for college, which does not have to be added back on the income portion of the financial aid application (FAFSA).

Parents of children with existing UTMA accounts should consider transferring the funds into a 529 plan before filing the FAFSA to convert a 20%-counted asset to a 5.64%-counted asset. However, any taxable gains triggered by the transfer will need to be considered for their potential impact on income tax and financial aid forms.

Finally, the possibility of reckless spending by their child should also drive many parents away from the thought of stashing large amounts into a UTMA account. The child will come into direct ownership of the funds upon reaching legal age, unless the custodian finds legitimate ways to "spend down" the UTMA before that date.

A 529 plan alleviates any concerns about a child getting their hands on the loot. The parent or other account owner forever remains in control, and even has the right to revoke the assets in the 529 plan.

In conclusion, you should feel free to use UTMA accounts for your college savings, but generally only to the extent they will not trigger the kiddie tax in any future years. For families capable of saving more substantial amounts for college, consider a strategy that includes both UTMAs and 529s.