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.

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.

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