Transferring a Custodial Account to a 529 Plan: Can and Should You Transfer?

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Transferring a Custodial Account to a 529 Plan: Can and Should You Transfer?
by Rande Spiegelman, CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research
August 17, 2006

Nearly every state offers a 529 plan, and for a very good reason—529 plans offer compelling tax advantages on money you invest for college:

The money you invest has the opportunity to grow tax deferred.
You can withdraw the money federally tax free to pay for qualified education expenses.
Your state may offer a state tax deduction for money contributed to its 529 plan.

If you were proactive enough to set aside money for your child’s college education before the days of 529 plans, you very well may have chosen a Uniform Transfers to Minors Act (UTMA) or Uniform Gifts to Minors Act (UGMA) account.

These custodial accounts are taxed based on the income earned and age of the child. They were once one of the only ways to receive limited tax benefits while saving for your child’s (or grandchild’s) college education, but they’ve been eclipsed by the federal tax-free benefits of 529 plans.

Can you transfer your child’s UTMA/UGMA into a 529 plan?
The short answer is yes. Most (but not all) 529 plans accept funds from an existing custodial account, and transferring the money into a 529 plan provides tax-deferred potential growth and federal tax-free withdrawals for qualified expenses.

Tax-deferred accounts can benefit even more from the power of compounding, which means your money could grow faster in a 529 plan than in a taxable account like a custodial. Also, in most cases you don't have to live in a particular state to take advantage of its 529 plan, so you can pick the plan that works best for you. However, by investing in a 529 plan outside of your state, you may lose any tax benefits offered by your own state’s plan.

There are several factors to consider before you transfer a custodial account to a 529 plan:

529 plans only accept cash. You must cash out the investments in the custodial account and pay taxes on any gains before you can transfer the money to a 529 plan.
You don’t gain control of the account. The money is still considered an irrevocable gift to your child, and he or she will have full access to it upon reaching the age of majority (generally age 18 or 21, depending on the state he or she lives in).
529 assets may only be withdrawn federally tax free for higher education. Any expenses not related to college could be subject to taxes and penalties, so you should be confident that your child plans to attend college.
Some 529 plans consider contributions after the initial transfer of funds to be subject to the rules of the originating custodial account. This means you lose the ability to change beneficiaries on the 529 account. Given this, it’s probably worth setting up two 529 plans, one for the UTMA/UGMA money and another for additional college savings.
Some providers add restrictions. Check with your financial institution before getting started.

Should you transfer your child’s UTMA/UGMA into a 529 plan?
529 plans offer definite benefits compared to UTMA/UGMA accounts—the biggest being tax-deferred potential growth and federal tax-free withdrawals. But you need to consider the total financial picture before making the change:

What’s your total tax bill once you cash out? You may decide you can’t foot the tax bill at this time. On the other hand, if there is little or no gain (or losses) then income taxes shouldn't be a barrier.
How long until college? If you have only a year or two until college, there may not be enough time for the tax advantages to make an impact.

Depending on your situation, you may decide that transferring your child’s UTMA/UGMA into a 529 plan is a smart financial move.

As with any investment, it’s possible to lose money investing in a 529 plan.

As with any investment, it is possible to lose money by investing in the Schwab 529 Plan. Before investing, carefully consider the plan’s investment objectives, risks, charges and expenses. This information and more about the plans can be found in the Schwab 529 Guide and Participation Agreement and Schwab 529 Summary of Recent Program Changes available from Charles Schwab & Co., Inc., and should be read carefully before investing. If you are not a Kansas taxpayer, consider before investing whether your or the beneficiary’s home state offers a 529 Plan that provides its taxpayers with state tax and other benefits not available through this plan.

The Schwab 529 College Savings Plan is offered through Charles Schwab & Co., Inc., and is managed by American Century Investment Management, Inc. The Plan was created under the provisions of Section 529 of the Internal Revenue Code by the Kansas Legislature and is administered by Kansas State Treasurer Lynn Jenkins, CPA. Accounts established under the Schwab 529 Plan are domiciled at American Century and not at Schwab.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. Each investor needs to review educational accounts based on his or her own particular situation. Data contained here are obtained from what are considered reliable sources; however, its accuracy, completeness or reliability cannot be guaranteed.

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