Your clients set up an UGMA or UTMA bank or brokerage account for their child or grandchild several years ago and have been gifting cash and securities into the account. Should they now convert the account to a 529 plan?
The answer depends on financial, tax and financial aid tradeoffs. Timing also matters.
Financial and Tax Consequences
Here are a few tax and financial reasons why it might or might not make financial sense to convert the UGMA or UTMA account to a 529 plan.
Minimal Tax Benefit from Conversion. The existing UGMA or UTMA account is probably already very tax-efficient, and the extra tax benefits of a 529 plan may not add up to much.
Under the Kiddie Tax Rules, the child’s first $1,100 of unearned income is completely sheltered by the standard deduction. Unearned income includes investment income, such as interest, dividends and capital gains. The next $1,100 of unearned income is taxed at the child’s income tax rate (10%). Any unearned income over $2,200 is taxed at the parent’s tax rate.
It takes a rather sizable UGMA or UTMA account to generate that much taxable unearned income each year. Also, consider that the kiddie-tax income threshold adjusts periodically for inflation.
Conversion Triggers a Big Tax Bill. All of the untaxed capital gains in the existing UGMA or UTMA account will be reported as unearned income if converted to a 529 plan. Contributions to a 529 plan must be made in cash, which requires liquidating the UGMA or UTMA account.
The bunching of capital gains in the year of conversion, as opposed to spreading them out over several years, makes kiddie-tax problems much more likely. And if the kiddie tax applies, instead of being taxed at the child’s 10% tax rate, the unearned income is subject to the parents’ much higher income tax rate (likely 22% or 24%).
By not converting, capital gains in the existing UGMA or UTMA account can be carefully managed over several years to minimize or avoid the kiddie tax and take full advantage of the child’s 10% tax bracket.
State Income Tax Benefits. More than two-thirds of the states offer a state income tax deduction or tax credit based on contributions to the state’s 529 plan. This is a benefit that is available on 529 plans but not UGMA or UTMA accounts. However, you could make new contributions to a 529 plan account instead of the UGMA or UTMA account without converting the UGMA or UTMA account to a 529 plan account.
Higher Expense Ratio. Most 529 plans charge a management fee. While 529 fees have come down dramatically over the years, it is still an extra cost that works against the decision to convert.
Better Investments in 529 Plan. Of course, this analysis assumes that the exact same investments are used in the existing UGMA or UTMA account and in the 529 plan. This rarely turns out to be the case. In fact, the investments offered by a 529 plan may be better quality and/or lower cost than what the client’s UGMA or UTMA account is currently invested in. The 529 plan may also offer a beneficial investment strategy – an age-based investment option – that is difficult to replicate outside of a 529 plan.
Lower Returns as College Approaches. An age-based asset allocation shifts the investment mix to a lower percentage equities as college approaches, bottoming out at 10% to 20% in stocks. Thus, the investment returns may not be much different than in the UGMA or UTMA account a few years before the child enrolls in college.
Financial Aid Impact
Financial-aid eligibility is the wild card that favors moving the UGMA or UTMA account assets into a 529 plan. The financial aid consequences can exceed the tax savings from keeping the money in an UGMA or UTMA account.
Outside of the 529 plan, those assets are reported as student assets on the Free Application for Federal Student Aid (FAFSA). Student assets on the FAFSA add significantly to the expected family contribution (EFC). The EFC is increased by 20% of the value of the student’s assets. But, moving those assets into a 529 plan allows them to be reported as parent assets on the FAFSA, which are assessed on a bracketed scale that maxes out at 5.64% when determining the EFC.
Assets are reported on the FAFSA as of the date the FAFSA is filed. So, the financial-aid advantage to conversion is available at any time up until the FAFSA is submitted. (Keep a printout from the UGMA or UTMA account and 529 plan web sites showing the new account balances if the conversion occurs after the most recent statement prior to the FAFSA filing date.)
Just be careful to time the conversion so that the triggering of capital gains does not work against financial-aid eligibility. The FAFSA is based on prior-prior year income, so any income on or after January 1 of the sophomore year in high school will be reported as income on the FAFSA. The EFC will increase by as much as half of this income.
Use our Financial Aid Calculator to estimate your expected family contribution (EFC) and financial need based on student and parent income and assets, family size, number of children in college, age of the older parent and the student’s dependency status.
The Bottom Line
Encourage clients to convert an UGMA or UTMA account into a custodial 529 plan account before January 1 of the sophomore year in high school. Otherwise, the capital gains from liquidating the UGMA or UTMA account will significantly reduce the student’s eligibility for need-based financial aid.
It is best to spread out the capital gains over several years prior to this year, to take maximum advantage of the lower tax rates on the first and second $1,100 of a child’s unearned income.
Use Savingforcollege.com’s UGMA/UTMA 529 Conversion Calculator to evaluate the impact of converting an UGMA or UTMA account into a custodial 529 college savings plan. This free tool is easy to use and displays the results in graph and table formats. Give it a whirl!
[The original version of this article was written by Joe Hurley. It was updated and rewritten by Mark Kantrowitz on July 9, 2020.]