Useful jargon: UGMA or UTMA in a 529



Dear Joe, Can you convert UGMA or UTMA accounts to a 529 plan? When I opened these college savings tools, 529 was not an option. -- Justin


Dear Justin,
The custodian of UGMA or UTMA funds may invest those funds with a 529 plan. I prefer the label "transfer" over "conversion" to describe the movement of assets out of a taxable UGMA or UTMA investment account and into a 529 plan. The transferred funds still belong to the minor child and you, as custodian, remain subject to the Uniform Gifts to Minors Act, UGMA, or Uniform Transfers to Minors Act, or UTMA.

You will be responsible for making certain that any withdrawals from the "custodial" 529 account are used for the benefit of the minor child. You cannot change beneficiaries on the account, and you must turn over control to the beneficiary at the age established under state law, generally 18 or 21. The enrollment forms for most 529 plans will inquire whether contributions are coming from existing UGMA or UTMA accounts. If you answer "yes," special restrictions may be placed on the account by the plan administrator to protect the interests of the minor.

Transfer boosts federal student aid
Transferring UGMA or UTMA funds into a 529 plan will increase your child's eligibility for federal student aid. Most student-owned investments, including UGMA or UTMA assets, must be reported on the federal aid application, the FAFSA, and are factored into the expected family contribution at the high rate of 35 percent (dropping to 20 percent with the 2007-08 school year). But under recent changes to the financial aid laws, student-owned 529 accounts are not reportable at all and have no impact on your child's eligibility for federal aid.

Parentally owned assets, including parent-owned 529 accounts, are counted for financial aid purposes on a sliding scale that tops out at 5.64 percent. You might wonder if it makes sense for parents to put their own money into student-owned or custodial 529 accounts. I generally recommend against it, for two reasons.

First, you would be giving up your ownership rights in the 529 plan. Forsaking those rights in an effort to reduce your expected family contribution by a small amount (5.64 percent of account value, at most) may lead to bigger problems down the road if your child decides the 529 funds are better spent on things other than a college degree.

Second, some members of Congress apparently feel the treatment of student-owned 529 accounts under the new law created an unintended loophole, and they want to fix it. We may see yet another amendment that assigns a 5.64 percent rate to student-owned 529 accounts, which would make it no better than a parent-owned 529 account, although it would still offer an advantage over other student-owned investments.

Change to 'kiddie tax' hurts
Since a 529 plan can only accept cash, the transfer of existing UGMA or UTMA investments into a 529 plan requires that those investments first be liquidated. The sale may trigger capital gains, so I suggest you plan carefully. Unfortunately, this year's change to the "kiddie tax," which increased the age limit from 14 to 18, means that many families face a much bigger tax bill when liquidating UGMA or UTMA investments. However, it might not be a good idea to wait until your child is 18 before selling those investments. Not only will you be carrying too much market risk in your college savings portfolio, but the reporting of gains just before or during the college years can substantially reduce your child's financial aid eligibility.

If you had known that Congress was going to increase the kiddie tax emancipation age to 18, you probably would not have placed substantial amounts of money into UGMA and UTMA accounts in the first place. Parents of younger children should keep this in mind when deciding how best to save for college. It's why I now refer to UGMA and UTMA as the newest four-letter words.