For years, parents have been stashing money in custodial accounts to fund their kids' college educations. They've saved on taxes, too, since a large portion of the bill is paid at the child's lower rate. But recent changes in the law sap so much of the tax savings from custodial accounts that state-sponsored 529 college savings plans, which are tax-free if used for education, are better deals. In fact, they're so much better that you may want to cash out your kids' custodial accounts and put the money in 529s.
How do you decide? Look at how long it is before your child matriculates, the amount of appreciation in the account, and the likelihood of qualifying for financial aid. For most families, "converting to a 529 account makes sense," says Sam Beardsley, director of investment tax for T. Rowe Price (TROW), a mutual fund company.
Custodial accounts, also known as UGMA/UTMA (Uniform Gifts to Minors Act/Uniform Transfers to Minors Act) accounts, can still be attractive for small sums. The first $850 in annual interest, dividends, and capital gains is tax-free, and the next $850 is subject to a child's low tax rates. Anything beyond that is assessed at the parents' marginal rates of up to 35% for interest income and 15% for qualified dividends and capital gains. In the past, once the child turned 14, the parents' rates no longer applied. But Congress recently extended the parents' tax rate to age 17 this year and to age 23 for dependent children starting in 2008. "The real benefit of the custodial account is gone," says Jim Sonneborn, a wealth manager at RegentAtlantic Capital in Chatham, N.J.
Cashing out a custodial account is a taxable event, and the account will owe capital gains tax on any investment profits. But financial advisers say taking that hit now can be worthwhile, because once the money is in a 529 plan, there are no taxes on investment earnings or withdrawals as long as the money is used for education. That tax savings should more than make up for the higher fees that 529 investors pay. (Money in a custodial account belongs to the child, who retains ownership if the money is transferred into a 529.)
Suppose your son's account has appreciated by $25,000, to $100,000. If you shut it and pay a 15% capital-gains tax on the $25,000 profit, the total tax bill would come to $3,750. That leaves $96,250 after taxes to put into the 529. Assuming the 529 and the custodial account each grow by 8% annually, it would take only a year for the 529 to catch up on an aftertax basis—even if the account holder pays 0.3% more a year in fees.
The breakeven point will vary. As a rule, if college is eight or more years away, Beardsley recommends liquidating a custodial account and transferring the proceeds to a 529 plan. If your child is older, the wisdom of such a move depends largely on your built-up appreciation. For example, if enrollment is four years away, you'll come out ahead by shifting to a 529 plan if the account has grown by up to 75%.
The federal financial aid formula also favors 529s. Currently, assets transferred from a custodial account to a 529 two or more years before college enrollment have no impact on financial aid. A bill before Congress would change that. Even if it passes, though, only 5.6% of the 529 would count against the family when computing aid, vs. 20% for custodial accounts. For many parents, that could seal the deal.
By Anne Tergesen