One common method of saving for children’s college education has been to utilize
Uniform Gift to Minors Act (UGMA) accounts. For more information on saving for
college, see our past article titled Crash Course in ‘Saving for College 101’, published in
our January 6th, 2008 column, or visit our website (see link below) and review our
articles on saving for college by clicking on our “In The News” web page.
In the past, parents often used custodial UGMA accounts to shelter their children’s
college savings accounts from the higher parental tax rates. Since the children typically
had little or no income, investment earnings were taxed at the child’s lower tax rates. In
order to avoid that loophole, Congress passed the so-called “Kiddie Tax” in 1986. Until
recently, the first $850 of unearned income was not taxable and the next $850 was taxed
at the lower tax rate of the child. Income above $1,700 was then taxable at the higher
tax rate of the parents. Then, at age 14, unearned income above $1,700 was taxed at
the child’s lower tax rate.
As a result, many parents would wait until their children reached age 14 to sell highly
appreciated UGMA assets, in order to trigger capital gains rates at their children’s lower
tax rates.
Then, on May 17, 2006, as part of the Tax Increase Prevention and Reconciliation Act
(TIPRA), Congress changed the age 14 restriction to age 18. To make matters worse,
effective January 1, 2008, the child must now reach the age of 19 before year end in
order for the kiddie tax to not apply for that year. In addition, the kiddie tax will continue
to apply even after your child reaches age 19 if all of the following apply:
• The child is a full-time student.
• The child does not attain age 24 by the end of the tax year.
• The child's earned income for the tax year does not exceed one-half of his or her
support.
• The child's unearned income exceeds $1,700, as adjusted for inflation in future
years.
• The child has at least one parent living at the close of the tax year.
• The child does not file a joint return for the tax year (which the child could only do
if married).
As a result of these changes, it may now make sense for parents to consider
transferring their children’s UGMA accounts to state-sponsored 529 plans. Since 529
plans can only accept cash, UGMA assets invested in stocks, bonds and mutual funds
will have to first be liquidated. This will trigger capital gains taxes at the parents’ tax
rate. Since the higher parents’ capital gains tax rate cannot be avoided for student
UGMA assets, selling those assets now and transferring to a 529 plan will at least avoid
future capital gains taxes as well as taxes on dividends and interest, as long as those
earnings in the new 529 plan are used to pay for qualified college expenses.
529 plan assets are also considered parental assets for purposes of financial aid, even
if the 529 plan is a custodial plan that was transferred from a UGMA account.
Therefore, transferring a UGMA to a 529 plan will improve your children’s chances of
receiving financial aid. UGMA assets are considered to be assets of the student and
therefore reduce the amount of student aid available.
Before transferring a UGMA account to a 529 plan, we always recommend you discuss
the tax consequences with your tax advisor.
David C. Patterson, CFP® and Erin Patterson, CFP® are the owners of Patterson Advisors, LLC, a fee-
for-service-only financial advisory firm. Patterson Advisors, LLC is a Registered Investment Advisor,
registered with the State of Michigan, helping clients in Waterford, Clarkston and Royal Oak, Michigan
as well as other Oakland County, Michigan communities . Visit www.pattersonadvisorsllc.com for more
information or call 248-674-2108.
Published in the Oakland Insider, April, 2008,
New Strategy Possible With Stricter “Kiddie Tax”
By David and Erin Patterson