Custodian can invest in 529 plan

10/15/2007

QUESTION:
Dear Joe,

I need information on possibly converting my custodial account to a 529 plan.

-- Larry

ANSWER:
Dear Larry,

Technically speaking, you cannot convert a custodial account to a 529 plan. However, you can decide to invest custodial assets in a 529 plan. If a custodian decides to open a 529 account, the custodianship, which was established under your state's Uniform Gifts to Minors Act, UGMA, or Uniform Transfers to Minors Act, UTMA, stays in place. Furthermore, the rights of the minor beneficiary do not change, which means the child takes direct control of the 529 account when the custodianship terminates at age 18 or 21.

Let's assume the UGMA or UTMA account is currently invested in mutual funds. The dividends and capital gains distributions generated by the mutual funds are taxable to the child. The kiddie tax will cause unearned income in excess of $1,700 to be taxed at the parents' tax bracket. This year the kiddie tax applies to children age 17 and younger. Starting in 2008, the kiddie tax is expanded to include most 18-year-olds along with full-time college students ages 19 to 23, unless they have earnings of more than one-half of their support.

By moving the assets out of mutual funds and into a 529 plan, you would be eliminating the tax on future investment earnings, assuming the 529 money is eventually distributed tax-free for college. For anyone subject to the kiddie tax, this can save substantial income taxes. However, the 529 plan will only accept cash contributions, so you would have to first liquidate the current investments. Upon their sale, any capital gains will be taxed to the child, possibly at the parents' rate because of the kiddie tax.

Some parents may be thinking about moving custodial assets into a 529 plan, not because of the potential tax savings, but because they want to prevent the child from controlling any unspent funds at 18 or 21 years old. Unfortunately for the parents, the laws protect the rights of the child. When the 529 account is established, the custodianship should be disclosed to the 529 plan administrator. A 529 plan tagged as a "custodial 529" will not permit a beneficiary change until after the minor takes direct control of the account after reaching the age of majority.

Custodial assets and income are generally treated as the student's assets and income when applying for financial aid, and they are assessed heavily in the aid eligibility formula. A special exception removes a dependent student's self-owned 529 plans and Coverdell education savings accounts, or ESA, from the free application for federal student aid, or FAFSA, for this school year (2007 to 2008) and next (2008 to 2009). Beginning with the 2009 to 2010 school year, student-owned 529 plans and ESAs will be treated as parent-owned 529 plans and ESAs -- still a good deal considering parental assets are counted at a much lower rate than student assets.

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