Before 529 programs became prevalent as an attractive vehicle for funding college education, many families utilized traditional custodial accounts (UTMA or UGMA). A primary benefit of these accounts is that, up to certain limits, any income generated from these accounts is not taxed or only taxed at the child’s tax rate instead of the parent’s presumably higher tax rate (see kiddie tax chart below).

KIDDIE TAX (may apply to unearned income of children under age 18*)

First $950 No tax
Next $950 10% tax
Unearned income over $1,900 Parents’ rate

*Kiddie tax also applies at age 18 unless child’s earned income represents more than one half of support needs. Tax also applies at age 19-23 if the individual is a full-time student and relies on parents for at least one half of support needs.

Over the years, the kiddie tax has been expanded to potentially affect individuals up to the age of 23 depending on circumstances. Considering the broader tax benefits, 529 programs represent a better way to save for and fund college education. Does it make sense for clients who still hold assets inside UTMAs or UGMAs to liquidate their accounts and use the proceeds to fund a 529? There are several reasons why this may be an attractive strategy:

  1. Tax benefits: 529 programs offer tax-free growth and tax-free withdrawals if funds are used for qualified higher-education expenses.
  2. Financial aid: According to current federal guidelines, 20% of assets in a custodial account are considered when determining a child’s eligibility for aid, compared with generally only 5.6% of 529 assets. Custodial assets are treated as assets of the student, while 529 assets are considered assets of the account holder, which is usually the parent. Also, grandparent-owned 529s are not included as part of the calculation for determining financial aid currently.
  3. Investment options: Lastly, UTMA and UGMA accounts do not generally include an age-based investment option, which has become a hallmark of the 529 plan. An age-based investment option adjusts its allocation automatically over time, placing a greater emphasis on preserving assets as a child gets closer to starting college.

Traditionally, parents had limited vehicles to save for college. But since their introduction a decade ago, 529 plans have evolved into a competitive offering that many parents may want to explore.