Online Extra: What About Those Custodial Accounts?

Though 529 plans are now more advantageous, these old favorites still have their uses

The custodial account has long held one big advantage as a college-savings vehicle. Because it's set up in a child's name and is managed by a parent only until the kid comes of age, the tax hit is less than it would be for mom or dad if the account were held in their names. But now that Congress has eliminated federal taxes on state-sponsored 529 college-savings plans, the custodial account has lost its luster. After all, why pay any taxes when you can avoid them entirely?

Custodial accounts -- often called UGMA or UTMA accounts, for the Uniform Gifts To Minor's Act and Uniform Transfers to Minors Act that created them -- can still serve a purpose. You can use them to underwrite expenses for your child aside from such basics as food, clothing, and shelter, says Christine Fahlund, senior financial planner at T. Rowe Price Advisory Services in Baltimore. Examples include camp, computers, music lessons, and elementary and high-school tuition.

But when it comes to saving for college, do it in a 529 plan. The 529's exemption from federal taxes (and often state taxes, too) makes it hard to beat. According to T. Rowe Price, if someone in the highest tax bracket sets up a custodial account and puts $5,000 a year into an equity fund that earns an average of 8% a year, this will generate $208,792 after taxes in 18 years. The same investment in a 529 plan yields $226,140 -- or 8% more.

MOVING YOUR MONEY. If you already have a custodial account for a child, your best bet is to leave it in place and open a separate 529 in your name for future contributions to your child's college nest egg. True, most 529 plans accept transfers of custodial money into accounts that are identified as custodial rollovers. But first, you must liquidate the custodial account and pay taxes on any gains.

Moreover, aside from the tax advantage, you get no benefits for transferring custodial money to a 529 plan. You won't regain control of the funds. Even in a 529 wrapper, custodial savings remain the property of your child, who's free to spend it as he or she pleases at the age of majority -- 18 in most states. If the child doesn't use 529 money for higher education, though, he or she must pay income tax and a 10% penalty on the account's earnings.

A 529 transfer won't erase the finanical-aid drawbacks associated with custodial money, either. Because the child continues to own the account, every dollar in it reduces your financial aid by 35 cents. The hit is only 6 cents per dollar saved for a 529 held in a parent's name.

If you need financial aid or are worried your child might blow the savings on a trip around the world, drain the custodial account to pay for items such as camp and computers. Then, you can deposit the out-of-pocket money you would have spent into a 529 in your name, says Joseph Hurley, whose compares state-sponsored college plans. If you're looking for tax savings and control, the 529 is the hands-down winner.

By Anne Tergesen

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