Experts say investors can loosen the binds of their restrictive UGMA or UTMA accounts and get into a 529 — with a few caveats.
It was supposed be a tax efficient way to invest money for children.
But irrevocable accounts set up under the Uniform Gift to Minors Act and the Uniform Transfer to Minors Act are like your father's Oldsmobile. They putter compared to newer, racier 529 savings plans — especially if you're socking away money to pay for college.
Luckily, experts say, investors can loosen the binds of their restrictive UGMA or UTMA accounts and get into a 529 plan account — with a few caveats.
"Given the significant decline in the market, many securities in UGMA accounts, or even entire accounts, may have unrealized losses, which can be beneficial from a tax standpoint," says Jennifer Ma, a research fellow with TIAA-Cref in New York, the largest 529 plan provider.
"By moving the cash over to a 529 plan ... individuals are exiting a situation where earnings can be taxed, to one where earnings can be except from federal tax and in most cases state taxes as well," she adds.
Adviser Stephen Gorman, president of Gorman Financial Management Inc. in Hingham, Mass., says clients have noticed the difference. He says they are asking about how to convert UGMA accounts, introduced in 1956, and UTMA accounts, introduced in 1986, into a 529 plan accounts.
Both UGMA and UTMA accounts, together generally referred to as UGMA accounts because they're so similar, pale in comparison to 529 plan accounts, which were created in 1996.
The biggest reason is tax savings. All the earnings from investments in a 529 plan account are tax exempt, while only a portion of the earnings in a UGMA or UTMA account are tax exempt.
Under one scenario, the 529 plan account would actually be owned by the UGMA or UTMA account. Experts in college saving say the tax advantages associated with 529 plan accounts, and the fact that the stock market has been so weak lately, make such a move doubly attractive.
Ms. Ma says the sooner investors make the transfer the better — in most cases.
In a 529 plan account, investments grow tax-free and, under the recently enacted Tax Relief Act, distributions for educational expenses can now be taken tax-free as well. On the other hand, only a portion of the earnings in UGMA and UTMA accounts are tax-free.
When the child is under 14, the first $750 of earnings each year is exempt from federal and state taxes, the second $750 is taxed at the child's rate, and the rest is taxed at the parent's rate. If the child is 14 or older, all earnings are taxed at the child's rate.
"If a substantial amount of unrealized capital gains has been accumulated in a UGMA and the child is approaching 14, then parents may want to wait until the child turns 14 to sell the securities," Ms. Ma says. "This is so because once the child turns 14, gains will be taxed at the child's rate, which is probably lower than that of the parents."
As a result, the tax bite may be smaller if the liquidation takes place after the child turns 14, Ms. Ma says.
Liquidating UGMA and UTMA account assets, however, and then taking the proceeds and putting them into a 529 can bring a host of problems — most of them relating to ownership.
UGMA and UTMA accounts are custodial accounts, the contents of which belong to the child, meaning the assets of the 529 purchased with the proceeds of the liquidated assets of a UGMA or UTMA account would belong to the child.
Normally, the assets of the 529 account belong to the parent.
UGMA and UTMA accounts also present a problem with respect to financial aid for college. Most financial aid formulas impose a penalty for assets owned by the student.
They also pose a problem for parents who just need to get hold of the money in an UGMA or UTMA account. Because the accounts are irrevocable gifts, the assets in them must be used for the child.
A 529 plan account is not irrevocable, although there is a 10% penalty on earnings for taking the money out before the child reaches a certain age.
Of course, issues of ownership can be sidestepped by just spending down an existing UGMA or UTMA, using the proceeds for the child's needs and buying a 529-plan account with new dollars independent of the UGMA, says Joseph Hurley, founder of Savingforcollege.com in Pittsford, N.Y.
Even Mr. Hurley admits that such a solution might not work for a child from a family that just doesn't have the money to sink into a 529 plan.
Of course, the custodian of a UGMA or UTMA account could just liquidate the account and move the money into a 529 plan without telling the 529 plan administrator where the money was coming from, suggests one financial adviser.
Such a move would be illegal, and the adviser recommends against it, but because there are no "UGMA or UTMA police," he says, he believes the practice is widespread.
Whatever the approach, it appears that 529-plan accounts are financial advisers' tool of choice for college savings. Consequently, it would be natural to assume that UGMA and UTMA accounts are on their way out. But Mr. Hurley says he doesn't think that's the case.
While many people use UGMA and UTMA accounts to save for a child's education, unlike 529 plan accounts, they are not necessarily intended for that purpose.
"Small custodial accounts still can be very useful," he says. "You don't have to use them for any particular purpose."
