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529 plan or UGMA: Which to use for college savings?

(MoneyWatch) One of my clients recently asked me if they should close out their UGMA (Uniform Gifts to Minors Act)/UTMA (Uniform Transfers to Minors Act) accounts in favor of increasing their contributions to 529 education savings accounts. Specifically, we discussed the options of either leaving their existing UGMA/UTMA accounts "as is," or closing these accounts and transferring the funds into a 529 plan account.

If you directed or transferred the funds in a child's UTMA into a 529 plan account then you would need to establish what is referred to as a UGMA/UTMA 529. This refers to an account in a 529 plan funded with money already owned by your minor child. Because minors generally cannot directly own an investment or bank account, an adult custodian must manage and use the funds for the benefit of the minor child as prescribed under the state's Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA). Another name frequently used for a 529 account opened with UGMA/UTMA money is "custodial 529 account."

According to the typical provisions of a 529 plan, you may use money from a Uniform Gifts/Transfers to Minors account to open an account or fund additional contributions to an existing 529 Plan account.

One of the differences between a UGMA/UTMA 529 and a regular 529 plan account is that the plan administrator will not permit changes in the beneficiary designation prior to the current beneficiary's 18th or 21st birthday (depending on the state). And when the current beneficiary reaches the age of legal ownership, he or she will have the right to contact the 529 plan administrator and take direct ownership and control of the 529 account.

Only cash can be transferred from a UTMA to a UTMA 529 plan account, therefore securities currently held in a UTMA would need to be sold. In doing so, you may incur capital gains taxes from the sale of the assets currently held in the UGMA/UTMA account. On the other hand, there could be substantial tax savings, assuming your child would otherwise be paying income tax on taxable interest, dividends, or capital gains on investments held in a UTMA. The 529 account will grow tax-deferred, and distributions used for qualified higher education expenses would be tax-free.

But you need to consider that your dependent child can report as much as $950 in investment income in 2012 without being subject to federal income tax. If your UTMA investments never generated more than $950 in annual investment income (dividends, interest or realized capital gains), you might be better off keeping the UGMA/UTMA invested in mutual funds and other taxable investments. Also, remember that the 529 plan has the disadvantage of the risk of future tax and penalty if the 529 account is used for something other than college.

If the existing UGMA/UTMA taxable investments are throwing off more than $950 in annual income, the analysis turns in favor of the 529 option. Although the income between $950 and $1,900 remains taxable at the child's low tax bracket, a rise above that level may become taxable at the parents' marginal tax bracket. This rate increase is known as the "Kiddie Tax".

Because of the control issues (children have outright ownership of UGMA/UTMA assets at age 21 in most states) and the Kiddie Tax, most parents looking to invest substantial dollars for future college expenses should be considering using 529 plans instead of UGMA/UTMA accounts.

That said, parents who have assets currently held in UGMA/UTMA accounts and want the child to preserve the ability to use these assets for financial needs OTHER than future college expenses (such as the purchase of a house, car, etc.) should consider leaving the assets in the existing UGMA/UTMA accounts and ensuring these are invested suitably for the child's time horizon and risk tolerance.

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