Kiddie Tax, UTMAs, and 529s
By Travis J. McShane, CFP®, CFA®
“Congratulations on the new baby!!”
“Where are you registered?”
“What size diapers should I drop off?”
AND…. “Have you opened a 529 account yet?”
Seems like an odd question out of the gate (and you should probably wait until the Social Security card comes in the mail) but recent changes in the tax law have expanded on the rules for 529 accounts, making them an extremely useful tool for helping the next generation get ahead whether they end up going to college or not.
We were often asked:
“What sort of savings account should I set up for my son/daughter (or grandson/granddaughter)?”
The response used to be:
“Will this be general savings to use for perhaps a car, future down payment on a house, or kickstarting long term savings?”
-or-
“Would you like to begin funding future college and higher education expenses?”
Which then puts you in an interesting spot of trying to guess how the next 18 years of a newborn’s life will pan out. For the college minded, the recommendation to open a 529 account was a slam dunk, and for those not wanting to tie the gifts to education specifically, it generally made sense to use a UTMA/UGMA account.
UTMA/UGMA accounts behave much like a regular brokerage account on a year-to-year basis. A gift is made to an account which is then usually invested with the appropriate time horizon in mind. That investment then spins off interest/dividends each year and/or generates capital gains/losses if any investments are sold. If those amounts add up to over $2,500 in 2024, then "Kiddie Tax" rules will need to be considered.
529 accounts behave a lot like Roth IRAs so long as any distributions are directed at qualified education expenses. Like UTMA/UGMA accounts, a gift is made to an account invested with an appropriate time horizon. All interest/dividends/capital gains are sheltered from taxes from year to year which eliminates the “Kiddie Tax” worry, and when college expenses finally come due, then using the 529 funds will escape any taxes on investment growth and income.
Now comes the fun part. With the passage of SECURE 2.0 legislation in late 2022, there is a new rule that allows $35,000 of “leftover” 529 money to be rolled into a Roth IRA on behalf of the beneficiary of the 529 account. This is a lifetime maximum rollover amount, and the 529 must be open for a minimum of 15 years. The funds to be converted also need to have been contributed more than 5 years in the past. For any unused 529 assets that qualify, annual Roth contributions ($7,000 in 2024) are permitted to be “rolled in” to a Roth IRA until the $35,000 lifetime limit is reached.
In effect, this takes some of the guesswork out of the “will they go to college?” conversation because your gift today could eventually turn into a Roth IRA account, opening the door for a literal “lifetime” of tax-free compounding of returns. It’s best to get that 15-year clock going early which opens this door.
As a side note, if your newborn is a child actor, a budding superstar, or has some other way of generating “earned income”, just let us know and we can skip the maneuvering above and simply open a custodial Roth IRA to fund from those earnings each year. For the rest of us, the 529 to Roth option creates flexibility for anyone looking to lend a hand to the next generation for college…. or not.
If you have any questions on this strategy or to get a 529 account started for someone you care about, don’t hesitate to contact one of our advisors here.