Before 529 college savings plans became a popular way to fund a college education, many families utilized traditional custodial accounts (UTMA or UGMA). As 529 plans evolved, the definition of qualified education expenses expanded, making these accounts more competitive with other savings vehicles.
Tax treatment and custodial accounts
A primary benefit of custodial accounts is that (up to certain limits) unearned income generated is not taxed or only taxed at the child’s tax rate instead of a higher tax rate. Once the child’s unearned income exceeds a certain amount, the additional income is taxed at the parent’s marginal tax rate. Examples of unearned income include dividends, and capital gains.
For 2024, here is how the kiddie tax is calculated:
- First $1,300 of unearned income—no tax
- Next $1,300 of unearned income—taxed at child’s tax rate
- Unearned income over $2,600—taxed at the parent’s marginal tax rate
Source: Internal Revenue Service, 2024.
The kiddie tax applies to children under the age of 18. Once the child reaches 18, the tax continues to apply unless the child’s earned income represents more than one half of support needs. It also applies at ages 19 to 23 if the individual is a full-time student and relies on parents for at least one half of support needs. The tax would not apply if the child is not considered a dependent of the parents.
For more details on the kiddie tax see, “Tax on a child’s investment and other unearned income (Kiddie Tax).” (www.irs.gov/taxtopics/tc553)
Considering the broader tax benefits, 529 programs may be a more tax-efficient way to save for college.
Advantages of funding a 529 account
Some parents may decide to liquidate their UTMA or UGMA accounts and use the assets to fund a 529 college savings plan.
There are several reasons to consider this strategy:
1. Tax benefits: 529 plans offer tax-free growth and tax-free withdrawals if funds are used for qualified education expenses. Qualified expenses include, but are not limited to, tuition and room and board at any accredited college. Up to $10,000 annually (per student) may be used for K–12 tuition. The state tax consequences of using 529 plans for K-12 tuition expenses will vary depending on state law.
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 under the Free Application for Federal Student Aid (FAFSA), 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 currently included as part of the asset or income tests for determining financial aid.
3. Investment options: 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.
4. Tax advantaged gifting: A special provision of 529 plans allows contributions equal to five years’ worth of gifts to a single beneficiary in a single year without triggering the federal gift tax. For 2024, the gifting limit is $18,000 annually for individuals and $36,000 for married couples electing split gifts. The five-year feature means that an individual could gift $90,000 into a 529 in a year, effectively front-loading five years’ worth of gifts.
Considerations before converting UGMA/UTMA assets to a 529
- Since a gift into an UGMA/UTMA is irrevocable, the custodian must utilize those funds solely for the benefit of that child. In fact, once the beneficiary reaches the age of majority, they automatically become the owner of the account. In contrast, parents who contribute funds directly to a 529 have the flexibility to change the beneficiary of the 529 account. Because of these rules, former UGMA/UTMA assets transferred to a 529 must be kept separately from other 529 assets, since the beneficiary on that portion cannot be changed.
- While 529 plans offer key tax benefits, funds must be used for qualified education expenses. Parents may want to retain some funds in an UGMA/UTMA to cover other expenses such as transportation, which is not currently considered a qualified expense for 529 plans.
- Converting funds from an UGMA/UTMA to a 529 requires liquidating those assets to fund the 529 with cash. Parents will want to review the potential tax consequences of liquidating UGMA/UTMA assets.
Traditionally, parents had limited vehicles to save for college. But since their introduction more than 20 years ago, 529 plans have evolved into the most popular option for funding a college education. Families may want to seek guidance from a professional financial advisor to set education savings goals and identify investment choices. College costs have risen dramatically in the last decade, making it important for families to make the most of college savings.
Getting started with a 529
Understanding how a 529 plan works is the first step. In addition to tax advantages, a 529 plan can offer a range of investment options. Explore Franklin’s resources and learn how a Franklin Templeton 529 plan can help you invest for your child’s education.
For more information, speak with your financial professional.
WHAT ARE THE RISKS?
All investments involve risk including possible loss of principal. Diversification does not guarantee a profit or protect against a loss.
Investors should carefully consider the 529 plan’s investment goals, risks, charges and expenses before investing. To obtain the Program Description, which contains this and other information, talk to your financial professional or call Franklin Distributors, LLC, the manager and underwriter for the 529 plan at (800) DIAL BEN/342-5236 or visit franklintempleton.com. You should read the Program Description carefully before investing and consider whether your, or the beneficiary’s, home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in its qualified tuition program.
Franklin Templeton’s 529 College Savings Plan is offered and administered by the New Jersey Higher Education Student Assistance Authority (HESAA); managed and distributed by Franklin Distributors, LLC, an affiliate of Franklin Resources, Inc., which operates as Franklin Templeton.
Investments in Franklin Templeton’s 529 College Savings Plan are not insured by the FDIC or any other government agency and are not deposits or other obligations of any depository institution. Investments are not guaranteed by the State of New Jersey, Franklin Templeton, or its affiliates and are subject to risks, including loss of principal amount invested. Investing in the plan does not guarantee admission to any particular primary, secondary school or college, or sufficient funds for primary, secondary school or college.
Franklin Templeton, its affiliates, and its employees are not in the business of providing tax or legal advice to taxpayers. These materials and any tax-related statements are not intended or written to be used, and cannot be used or relied upon, by any such taxpayer for the purpose of avoiding tax penalties or complying with any applicable tax laws or regulations. Tax-related statements, if any, may have been written in connection with the “promotion or marketing” of the transaction(s) or matter(s) addressed by these materials, to the extent allowed by applicable law. Any such taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax professional.
This material has been provided for informational purposes only and should not be construed as investment advice or a recommendation of any particular investment product, or strategy.
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