UTMA to 529: Tax Consequences

Is there a tax benefit when you move UTMA funds to a 529 account? Or a tax cost? Depending on circumstances, you could see either one, or some of both.

Taxable vs. exempt

At the simplest level, this is a choice between a taxable account and one designed to provide tax-exempt investment earnings. Income and gain produced in a UTMA account is subject to the same rules that apply to investment earnings in any other taxable account. In a 529 account, no tax is due before earnings are distributed, and when distributions are used to cover college expenses the earnings are permanently tax-free.

Yet the tax comparison is not the no-brainer that it may appear:

• Although a UTMA is a taxable account, its earnings may escape taxation.
• Although earnings in a 529 account are potentially tax-free, sometimes the account is not used for qualifying educational expenses, resulting in tax and a penalty.
• Costs of moving the account may reduce or eliminate the overall benefit.

Potentially tax-free UTMA account

Although investment earnings in a UTMA account are taxable, they may escape taxation if the annual amount is small enough. The earnings are taxable to the minor, not to the custodian or donor. Often the minor has no other taxable income. In this case, an amount equal to the standard deduction allowed for a dependent ($1,050 as of 2016) is free of tax. Depending on how it’s invested, a UTMA account holding $10,000, or even $20,000 or more, could produce annual income below that threshold.

What’s more, investment earnings that escape taxation this way are permanently tax-free, without regard to how the money ends up being used. If the minor ends up not going to college, but needs the money to start a business or for a down payment on a home, the UTMA will produce a superior tax result.

It’s a different story, of course, if the minor has enough income to pay tax on the UTMA account’s earnings. The next $1,050 is taxed at the minor’s rate, and after that, the kiddie tax kicks in, applying the parents’ tax rate to the minor’s earnings. Moving a UTMA account that produces large amounts of annual investment earnings to a 529 account that will end up being used for college expenses may produce substantial tax savings.

Potentially taxable 529 account

You can extract tax-free earnings from a 529 account only if you apply those earnings to qualifying expenses. If the account ends up being used for other purposes, the portion of a distribution representing earnings will be taxable under unfavorable rules:

• Tax will apply to all the earnings that accumulated in the 529 account over the years, not just earnings in the current year.
• Earnings will be taxed as ordinary income, even if they were produced in the form of long-term capital gain or qualifying dividends that would otherwise qualify for lower tax rates.
• A 10% penalty will be tacked onto whatever tax applies to the earnings.

As an example, you might have a capital gain that would have been taxed at 15% in a regular investment account but when pulled out of a 529 account for a nonqualifying purpose is taxed as ordinary income at 25% plus a 10% penalty for overall tax of 35%.

It’s possible to gain some tax benefit from the rules for 529 accounts even when the investment earnings end up being taxable, because tax on those earnings is deferred, possibly for many years, until withdrawn from the account. Tax deferral is an advantage, but won’t easily overcome the added cost of the 10% penalty.

Toll charge

Tax savings from making this move may be at least partially offset by tax costs (or other costs) associated with the transfer. A 529 account can accept contributions only in cash, so investments in the UTMA account would have to be liquidated. Assets that have grown in value will produce capital gain that will be taxable to the minor (but potentially at the parents’ tax rate).

Bear in mind that this gain would likely be taxable at some later time, so this may be a case of paying tax sooner rather than paying an additional tax. What’s more, the usual benefit of deferring tax may not apply here, because we’re anticipating that future growth of the investments will end up being tax-free. If you leave the investments in the UTMA account, the entire gain will be taxable when the assets are sold, including growth in value that occurred after the date when the transfer might otherwise have occurred. Individual circumstances will dictate whether the need to pay capital gains tax when cashing out a UTMA account for transfer to a 529 account will actually end up being a net cost of making the move.