Why 529s Make Sense

Both my children, ages 2 and 5, have mutual funds in custodial accounts, which I opened up soon after they were born. Should I transfer this money into 529 accounts? The 529s seem to have changed a lot over the past five years

You're right. The 529 college savings accounts have improved significantly over the past few years, and some of the biggest changes came in the last few months. Two new tax laws make 529s much more attractive than custodial accounts. The 529 earnings are now permanently tax-free when used for college costs. And a change in the kiddie-tax law requires parents to pay taxes on custodial account earnings at their own tax rate until their children reach age 18 (previously, earnings had been taxed at the child's lower rate after they turned 14). Plus, more states continue to offer income-tax deductions for 529 contributions.

And new financial aid rules give 529s a clear edge: Custodial accounts are considered to be the child's assets, and children are expected to contribute 35% of their assets for college costs (the number shrinks to 20% next year); 529s are parental assets and only tapped at 5.6% in the financial aid formulas.

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Because of these new rules, it's better to invest the bulk of your college savings in a 529 plan. You also could switch money from your custodial account into a 529 and benefit from future tax-free growth. The account would be a "custodial 529," which means that your children gain control when they reach the age of majority and you can't switch the beneficiary. It isn't treated as a student asset for financial aid, even though the child controls the money.

But there's a big catch to moving the money: You can contribute only cash to a 529 account, so you'd need to sell the mutual funds and pay capital-gains taxes before you can make the switch. However, the new kiddie tax law makes that tricky because the profits will be taxed at your own rate until the year that your child turns 18 (generally 15% instead of 5%).

If your children are nearing college age, you can minimize the tax bill if you keep the money in the custodial account until age 18 and then sell the funds -- especially in 2008 to 2010, when the lowest capital gains rate falls to 0%. Or if your children owe taxes on the profits, they can use the Hope or lifetime learning credit to help offset the tax bill, says Rick Darvis, a certified college planning specialist in Medicine Lake, Mont.

If you're worried about the impact on financial aid, wait until the junior year of college to sell the funds or take out loans and use the custodial money to pay them back soon after your child graduates, says Gary Carpenter, a CPA and college planner in Syracuse, N.Y.

Because your kids are younger and have held the investments for only a few years, you might not face a big tax bill on the profits -- even at your own rate. In that case, it might be worthwhile to sell the funds now and pay taxes on the profits, then benefit from more than a decade of tax-free growth in the 529s.

But you don't want to switch too much money to a 529, warns Deborah Fox of Fox College Funding in San Diego. If you pay the entire college bill with a 529, then you can't take the Hope or lifetime learning tax credit. And if you have 529 money left over after your children finish school, you'd need to switch the beneficiary or pay a 10% penalty (plus taxes on the gains) to access the money.

For more information about saving for college, see our College page.