529 Plan: versus UTMA

||  This article is part of a series on the 529 Education Savings Plan  ||

Back in the day, your parents, grandparents, or some other random person might have chosen to express their financial affection by depositing money in a qualified account under the Universal Transfer to Minors Act (UTMA).  The UTMA, itself an extension of the Universal Gifts to Minors Act (UGMA), was originally proposed in 1986 and was ratified as law in most states shortly thereafter.  This law provided a mechanism to transfer ownership of securities, such as stocks, bonds, and mutual funds, to a minor without the complexity of establishing a trust fund.  They were quite popular throughout the 90's, and many young adults today find themselves approaching, or having recently surpassed, the age at which they assume custodianship of these account (18 or 21, depending on the state).

In 2001, things got more complicated: with the passage of the Economic Growth and Tax Relief Reconciliation Act (EGTRRA), there was now another option to pass some cash on to the next generation: the USC 26 Section 529 Education Savings Plan (529 Plan).

The 529 Plan is designed to be an improvement over a UTMA account in most situations, but like most things in life, you can't get something for nothing.

The Showdown: 529 vs UTMA

While the UTMA was often used as a means for a relative to help pay college tuition, the account custodian has legal authority to use the funds for anything that benefits the minor.  In contrast, the 529 Plan is designed solely to cover higher education expenses—any other use of 529 Plan funds is a 'nonqualified withdrawal', subject to income tax and a 10% penalty tax.  If you wish to gift money or investments and the beneficiary will not be attending college or a vocational school, a UTMA account (or a formal trust, which can be complicated and expensive to establish) is the only option.

For those more familiar with the UTMA, it can be instructive to contrast the rules differences with the newer 529 Plan.  For those who currently hold UTMA accounts, this comparison is helpful for making the decision of whether you should roll the UTMA money over into a 529 Plan.

Contribution Limits and Change-Of-Beneficiary

Contributions to a 529 Plan account can continue at any age until the account value reaches ~$300,000; UTMA contributions must cease when the beneficiary reaches the statutory vesting age—18 or 21, depending on the state—and assumes full ownership and control of the account.  While the 529 Plan Five-Year Rule offers the possibility of contributing a lump sum and spreading out the tax consequences over multiple years, the UTMA offers no such thing.

The beneficiary of a 529 Plan can be changed, which is not an option for a UTMA account.

Revocability and The Estate

As discussed in the previous article, assets contributed to a 529 Plan are no longer considered part of your estate for tax purposes.  However, you maintain complete control over the allocation and withdrawal of those assets, and you can reclaim the funds at any time and for any reason.

In contrast, UTMA accounts do not allow reclamation by the donor.  Assets contributed to a UTMA account become the property of the beneficiary at the statutory vesting age, at which point the donor has zero control over use of the funds.  Donors concerned about estate taxes must be extremely careful to avoid naming themselves as the UTMA account's custodian; if they die before the beneficiary reaches the vesting age, the account will be counted in estate tax calculations.

Student Aid Impact

As discussed in the previous article, how 529 Plan assets and withdrawals affect the beneficiary's student financial aid eligibility depends on who owns the Plan.  In the best case, the 529 Plan's funds are considered parental assets and have only a minor effect on federal student aid eligibility, and 529 Plan withdrawals have no negative effects at all.

For the beneficiary of a UTMA account, the impact on financial aid is always the worst-case scenario.  Money in the plan is counted as the student's assets, and has a much more significant impact (-20%, versus -5.6% for parental assets) on aid eligibility.  Capital gains accrued on UTMA assets count as the student's income, which reduces aid eligibility by a whopping 50% of the gain amount.

UTMA to 529 Plan Conversion

Given these facts, you may decide that it's advantageous to move money out of an existing UTMA and into a 529 Plan.  The UTMA can be cashed out, all at once or over several years, and the money deposited into a 529 Plan.  The unique nature of the UTMA account necessitates careful consideration of the details.

Because the money started in the UTMA, it belongs to the student and it should be put in a separate 529 Plan to avoid commingling assets that belong to the donor or parents.

Cashing out the UTMA is a taxable event - the student must pay tax on any capital gains they have accrued. The parents may file the student’s taxes as an addendum to their own using Form 8814, eliminating the need for the student to file their own tax return.

The first $950 (2013) in capital gains are tax-free; the next $950 is taxed at the child’s rate of 10%. Capital gains over $1900 must be taxed at the parents’ marginal income tax rate. If the child has significant qualified dividends or long-term capital gains, they should file their own return, as this income may receive a preferential rate:
If your child received qualified dividends or capital gain distributions, you may pay up to $95 more tax if you make this election instead of filing a separate tax return for the child. This is because the tax rate on the child’s income between $950 and $1,900 is 10% if you make this election. However, if you file a separate return for the child, the tax rate may be as low as 0% (zero percent) because of the preferential tax rates for qualified dividends and capital gain distributions.”
If the student files their own tax return, they will use Form 1040; if they earn over $1900, add Form 8615.

To reduce the taxes paid, make the total transfer over multiple years if possible. Each year, try to limit your capital gains income to avoid paying the parents’ marginal income tax rate on it.

For more information on potential tax implications:
IRS Topic 553 - Tax on a Child's Investment Income
IRS Publication 929 - Tax Rules for Children and Dependents