My Estate Planning Strategy includes a UGMA account for my grandchild (or child). Can I (or should I) switch to a college savings plan or a trust?
I regularly get variations of that question. A Uniform Gift to Minors Act (UGMA) account is the traditional vehicle to save and invest for a youngster (it’s UTMA in some states). The accounts are easy to set up through any financial institution, and transfers qualify for the $10,000 annual gift tax exclusion. Income and earnings are taxed to the child, and an adult controls the account until the youngster is of legal age.
But long time readers know the disadvantages of UGMAs.
The main disadvantage is that the youngster gets full legal title at age 18 or 21, depending on the state. Parents and grandparents cannot legally prevent the new adult from spending the account on cars, travel, clothes, or less desirable things.
Alternatives to UGMAs are trusts or accounts jointly owned by both the youngster and an adult. More recently, Section 529 savings plans have joined the competition. To me, 529 plans are the best choice for new contributions for the benefit of a child or grandchild.
A 529 plan allows a one year tax-free gift of up to $50,000, and the earnings of the 529 plan compound tax deferred instead of being taxed to the youngster. The parent or grandparent who sets up the account can get the money back or change the beneficiary. That’s a big help if the financial situation of the account owner changes. It also helps if the youngster does not attend college, gets a full scholarship, or becomes financially irresponsible. (See my January 2001 and March 2001 issues or the web archive for a review of 529 plan features.)
In the past, the UGMA and a 529 plan could be invested to earn about the same after-tax return. But the 2001 tax law changed that. Beginning in 2002, distributions from a 529 plan that pay for qualified education expenses became tax-free.
A further advantage of a 529 plan is that many states allow deductions against state income taxes (but not the federal income tax) for contributions to the 529 plan maintained by the state. The deductions can be substantial. In my state of Virginia, the annual deduction limit is $2,000 per student. (Contributions can exceed that amount, and non-deducted contributions are carried forward until deducted. Also, there is no limit on deductions if you are age 70 or older.) In Colorado there is no limit to the deduction. Missouri’s deduction limit is $16,000 per couple; New York’s is $10,000 per couple; and Mississippi’s is $20,000 per couple.
When the tax advantages are combined with the additional adult control, a 529 plan clearly is superior to the alternatives for new contributions meant to provide higher education for a child or grandchild.
What if you already have money in a UGMA? Can you transfer it to a 529 plan or a trust?
Here’s where things get tricky, and the answer might depend on your state.
Once deposited in a UGMA, money can be spent only for the minor’s benefit. The money cannot be returned to the adult who contributed it, and it cannot be spent on the legal support obligations of the parents.
Legal support obligations vary from state to state. College certainly benefits the minor, and it generally is not considered a legal support obligation. So, you should be able to transfer the UGMA to a 529 plan.
But the minor must be considered the owner and beneficiary of the 529 account for the UGMA transfer to be legal. The parent or grandparent won’t be able to change beneficiaries or get the money back.
Unfortunately, not all state 529 plans allow the beneficiary and owner of the account to be the same person. Fidelity says specifically that it cannot accept direct transfers from UGMAs for the 529 plans it manages for New Hampshire, Massachusetts, and Delaware.
Virginia and Iowa, however, accept UGMA transfers to their plans, and they accept contributions from residents of any state. You simply indicate on the application that it is a UGMA transfer so the plan knows the beneficiary also is the legal owner. To be sure of the legality, you need to consult an expert in your state’s UGMA law.
If the UGMA is transferred to a 529 plan, the minor is the one entitled to any tax deduction for the 529 plan contribution. That won’t hurt you, since you didn’t get an income tax deduction for the initial UGMA contribution.
But there could be a tax cost to transferring an existing UGMA to a 529 plan. You cannot transfer the specific assets in the UGMA to the 529 plan. You have to sell the UGMA holdings and transfer cash. That might mean incurring capital gains taxes on the liquidation.
The tax bill might not be too high. Any losses will offset gains. Plus, the gains are taxed to the child. That means if the child is under age 14, the first $700 is tax free. The next $700 is taxed at the child’s rate. The remainder is taxed at your rate. If the child is 14 or older, all gains are taxed at the child’s rate. Most likely, the gains will be primarily long-term capital gains, resulting in a maximum tax rate of 20% at your rate or 8% at the child’s rate.
The capital gains taxes would be incurred ultimately when the UGMA would be liquidated to pay for the education expenses. The issues are: How much will the taxes be if the account is liquidated now? Would you rather pay those taxes now and get the after-tax amount earning tax-free gains for the future, or would you rather leave the UGMA as is and make future contributions to a 529 plan?
Here’s a summary of my estate planning recommendations:
Consider transferring existing UGMAs to 529 plans in Virginia, Iowa, or another state that will accept a transfer from an UGMA.
If transferring the UGMA to a 529 plan doesn’t satisfy you – because the student still has legal control, and you are concerned about how the youngster will spend the money – consider spending down the UGMA before the youngster gets control. You can spend the account on items that are not the parent’s legal support obligation, including computers, cars, the child’s share of family vacations, televisions, and sound systems.
For future savings, establish a 529 plan with you as owner. If your state allows income tax deductions for 529 plans, establish an account there and make at least the maximum deductible contribution you can afford.
If you can afford contributions that exceed the available tax deduction, make additional contributions to your state’s plan or to another state’s plan with better features. Plans can be compared at collegesavings.org or by calling 877-277-6496.
Most 529 plans accept accounts from residents of any state to be spent on a college in any state. Next month I’ll review the factors to consider when evaluating the 529 plans of each state and give you some tips on which estate planning strategy might be best for your family.