Cutting Out The Kiddie Tax: Why You May Want To Consider Moving To A 529 College Savings Plan
Raj Mundhe, CRPC
For more than a decade, parents have been stashing income in custodial accounts like Uniform Gifts to Minors Act or Uniform Transfers to Minors Act (UGMA/UTMA) accounts. The intent was to fund a child’s college education while saving on taxes. In the past, custodial accounts were taxed at the child’s lower rate, once he or she turned 14 and until he or she enrolled in college.(If you’d like to learn more about education savings plans, please call Raj Mundhe, Morgan Stanley Smith Barney, at 781-672-5111 )
In 2007, Congress extended the tax rate to age 17. As of January 1, 2008, the so-called ‘Kiddie Tax’ was extended to age 23. The new legislation makes the taxation of custodial accounts more complex, as well as more expensive.
A 529 plan works a bit differently. It is not taxed at all on investment earnings or withdrawals, as long as the money is used for qualified higher-education expenses. When compared to custodial accounts, 529 plans are considered more effective from a tax efficiency standpoint. Therefore, investors saving for their children’s higher education expenses may want to explore liquidating their existing account investment and moving the proceeds to a custodial 529 Plan. In addition, transferring an UGMA or UTMA into a 529 savings plan may also allow for limited impact on financial aid.
Once a 529 plan account is funded with the proceeds from a custodial account, the Beneficiary cannot be changed and the custodian is not able to take a non-qualified distribution. Although cashing out a custodial account is a taxable event, some investors may find it worthwhile to pay the taxes now, with capital gains rates being at historical lows. The tax savings — over the long-term — will likely make up for any higher fees paid by a 529 plan investor. Plus, when it is time to tap the 529 plan to pay for college costs, the tax bill on any gains will be zero, as long as the withdrawals are used for qualified higher-education expenses. Your financial advisor can help you determine whether funding a 529 college savings plan with the proceeds from a custodial account is in your best interest.
Investments in a 529 plan are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so an individual may lose money. Before your clients invest they should review a Program Disclosure Statement, which contains more information on investment options, risk factors, fees and expenses and possible tax consequences. Account owners should read the Program Disclosure Statement carefully before investing.
If an account owner or the beneficiary resides in or pays income taxes to a state that offers its own 529 college savings or pre-paid tuition plan (an "In-State Plan"), that state may offer state or local tax benefits, but only for participation in the In-State Plan. These tax benefits may include deductible contributions, deferral of taxes on earnings and/or tax-free withdrawals. In addition, some states waive or discount fees or offer other benefits for state residents or taxpayers who participate in the In-State Plan. An account owner may be denied any or all state or local tax benefits or expense reductions by investing in another state's plan (an "Out-of-State Plan"). In addition, an account owner's state or locality may seek to recover the value of tax benefits (by assessing income or penalty taxes) should an account owner rollover or transfer assets from an In-State Plan to an Out-of-State Plan. While state and local tax consequences and plan expenses are not the only factors to consider when investing in a 529 plan, they are important to an account owner's investment return and should be taken into account when selecting a 529 plan.
Tax laws are complex and are subject to change. This information is based upon current tax rules in effect at the time this was written. Morgan Stanley Smith Barney and its Financial Advisors do not provide tax or legal advice. Individuals should always check with their tax or legal advisor before engaging in any transaction involving 529 plans, Education Savings Accounts and other tax-advantaged investments. This material was not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer under U.S. federal tax laws.
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