Rolling a Custodial Account Into a 529

If a minor child has a custodial account with the funds invested in CDs, what advantage is gained if they are rolled over into a 529 account? The amount is currently $30,000 in CDs and $10,000 in a money-market account, and we plan to use it for college costs in 2009 or 2010.

There are two good reasons to roll the money into a 529 account: taxes and financial aid. With the custodial account, your child is paying taxes on the interest he earns every year. You can avoid the tax bill by moving the money into a 529 account.

You can only invest cash in a 529, so you would have to sell the investments before making the switch. That would trigger a capital-gains tax bill for money that had been invested in stocks or mutual funds. But you don't need to worry about that tax bill because the money was in CDs and a money-market account.

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Regarding financial aid, the federal formula requires students to contribute 35% of their assets to their education, versus just 5.64% for parental assets. And money in a 529 plan is considered a parental asset.

Starting July 1, money transferred from a custodial account to a custodial 529 account also will be considered a parental asset. Because it's a custodial arrangement, the money still technically belongs to your child. But thanks to a loophole in the Deficit Reduction Act of 2005, says Joe Hurley, of Savingforcollege.com, it gets the more favorable parental status for financial-aid purposes.

And there's more good news: Several states offer higher-yield investments for the 529 money you'll need in three years. Hurley cites Ohio's FDIC-insured savings account yielding 4%, CollegeSure CDs in Arizona and Montana that are pegged to an index of private-college tuition hikes (which translates to about 4.12% for the year) and TIAA-CREF's guaranteed option in the 529 plans it manages. For example, Minnesota's plan managed by TIAA-CREF is yielding 3.65% through March 30, 2007.