UTMA and UGMA Custodial Account Conversions: Moving to a 529 Plan
Families often find themselves stuck between a rock and a hard place trying to figure out how to pay for college after receiving financial aid from their preferred schools. That's because there's usually a significant gap between what the school costs annually (in terms of tuition, books, and student housing) and the financial aid available to an incoming student.
This gap can be covered through scholarships, student loans, or personal savings. Some families have saved money for this purpose through UGMA (Uniform Gift to Minors Act) and UTMA (Uniform Transfer to Minors Act) custodial accounts.
Converting UGMA/UTMA to Section 529
UGMA and UTMA reigned supreme over the college savings market until the creation of Section 529 accounts in 1996. Since that time, most families choose Section 529 plans rather than UGMA or UTMA funds, as they offer a combination of tax benefits and parental control over the fund's assets. Given the popularity of these newer investment choices, it’s no surprise then that many parents and grandparents (who previously utilized UGMA and UTMA custodial accounts) may feel a little cheated.
Hence, a question often asked by parents who have invested in a UTMA or UGMA accounts is whether they can convert their investment to a Section 529 plan. The short answer is “yes," but this conversion has lots of important details to consider.
Control of the Assets
A UTMA-529 or UGMA-529 account conversion may impact who controls the assets. In some cases, the Section 529 plan sponsors require special handling and labeling of these conversions. In these instances, the specific account is labeled as a “Custodial Section 529 account” and the plan sponsor will turn the assets over to the minor when they reach adulthood, just as if it was a classic custodial account. This usually occurs when the child reaches the age of 18 or 21, depending on the state.
There are some plan sponsors, however, that do not require this special account treatment even though there is still a legal obligation remaining for the parent or grandparent. Some parents might be tempted to misrepresent the source of these funds when they fill out the Section 529 account form to avoid this possibility, but that is not advisable since it is not legal and allows your child to sue you for mismanagement of their money.
There is no ability to transfer a UGMA or UTMA account to another child or to change beneficiaries. You are not supposed to use a UTMA-529 or UGMA-529 account conversion to change the beneficiary either because that would equate to giving your child’s money to someone else.
If you make a UGMA-529 or UTMA-529 conversion and report it honestly, most plans will not allow a change of beneficiary until the currently listed beneficiary becomes the outright owner. At that point, the grown child is permitted to change the beneficiary from themselves to someone else, if he or she so desires.
Tax Consequences of a Conversion
Unlike IRAs that penalize you if you withdraw your money and invest it in a non-IRA account, a UGMA-529 or UTMA-529 conversion has no such penalty. However, the underlying investments in your account may be subject to capital gains tax if they have a previously unrealized gain. This possibility has to be weighed against the benefit of sheltering all future growth on the money under the new Section 529 plan.
Effect on Financial Aid Eligibility
A UGMA-529 or UTMA-529 conversion is generally considered a positive move when it comes to qualifying for financial aid. This is because the assets of a custodial account are counted as the child’s assets, but the assets in the converted 529 account are now counted as belonging to the parents if the student is still a dependent.
This means that by converting a UGMA or UTMA account to a Section 529 account, only 5.64% of the assets are expected to be used annually by the parents, as opposed to 20% being used by the student prior to the conversion.
Before making any decision on a UGMA-529 or UTMA-529 account conversion, it is a good idea to call your state’s Section 529 plan sponsor or consult with your investment and tax advisors.