Do you have savings for your child’s college education in a custodial account? If so, you may be wondering if you can transfer the assets into a 529 college savings plan since qualified withdrawals from these programs are free from federal tax.

Some 529 plans do accept transfers from custodial accounts. But before you make any moves consider the pros and cons. Depending on your situation, making the transfer may pay off. However, you might be better off leaving your existing assets in the custodial account and contributing future savings to a 529 plan instead.

The tax consequences

529 college savings plans only accept cash contributions. So before you can make a transfer you have to sell the assets in the custodial account and any gains are taxable on your child’s tax return.

Once you make the transfer, however, the assets grow tax free, which could be a substantial benefit if college is still far off.

Loss of investment flexibility

In addition to the tax consequences when you transfer custodial assets to a 529 plan, you lose the investment flexibility and options available through a custodial account. Custodial accounts allow you to invest in cash, CDs/share certificates, U.S. Savings Bonds, mutual funds, stocks, bonds, and most any other type of investment.

Specifically, under the Uniform Transfer to Minors Act (UTMA) rules that govern custodial accounts in almost all states, you can invest in any type of real or personal property.  And under the Uniform Gift to Minors Act (UGMA) rules that govern custodial accounts in the remaining two states, you can invest in most types of property, specifically excluding real estate and artwork.

In contrast, 529 college savings plan investments generally include a limited number of stock, bond, fixed income, and money market mutual fund options, as well as age-based portfolios of mutual funds. Furthermore, 529 plan rules only allow you to change your selected investment options within the same plan once a year.

Control of the account

Even after you transfer a custodial account to a 529 plan, the account retains its status as a custodial account. Consequently, the assets continue to be owned by your child and your child gains control of the assets when custodianship ends at the age of majority in the state, typically age 18 or 21.

In contrast, under 529 rules for regular accounts, the parent is the owner and can continue to control the account even after the child reaches the age of majority.

Therefore, transferring assets to a 529 plan is not a way to regain control of money in a custodial account, if that’s your purpose. The transfer may, however, discourage a child from using the money for purposes other than college. That’s because non-qualified withdrawals are subject to tax on earnings and generally a 10% tax penalty.

Also in contrast to regular 529 rules, you can’t change the account beneficiary on assets transferred from a custodial account – even if your child doesn’t attend college. And because the assets belong to your child you can’t take the money back, except to pay for expenses that benefit the child allowed under the UTMA or UGMA rules.

In contrast, in a regular 529 account you can take your money back by making a non-qualified withdrawal, even though you’ll incur income taxes on the earnings and generally a 10% tax penalty.

Financial aid implications

Under current federal financial aid rules, as owner of the college savings plan your child is considered to have 35% of 529 plan assets available each year to pay for college. In contrast, for regularly funded 529 plans the parent as owner is considered to have only about 6% available.

Remember, though, most financial aid is awarded in the form of loans and non-needs based aid is available if you don’t qualify for needs-based aid.

Article is for educational purposes only and is not intended to provide specific tax or legal advice. For answers to tax questions, please see your tax professional. For legal questions, consult an attorney.

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