College is an expensive endeavor.
According to the National Center for Education Statistics, for the 2016 – 2017 academic year, undergraduate tuition, fees, room, and board were estimated to run $17,237 at a public institution, $44,551 at a private nonprofit institution, and $25,431 at a private for-profit institution.
For that reason, many parents start saving for their child’s college education while that child is still in diapers.
There are several ways to save for education. People often think of 529 plans when it comes to saving for college, but you can also use Uniform Gift to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA) accounts. Each account has different benefits and drawbacks.
Before choosing how to save for your child’s education, learn more about how these accounts work and what features they offer.
529 Plan, UGMA, & UTMA Defined
Before delving into the pros and cons of these accounts, it pays to understand what each account is.
A 529 savings plan is a tax-advantaged account named after Section 529 of the Internal Revenue Code. These accounts help you save for education.
Money in the account accumulates tax-free, and distributions are tax-free as long as you use the money for qualified education expenses.
Qualified expenses include:
- Required tuition and fees
- Books, supplies, and equipment
- Computers, peripheral equipment, software, and Internet access
- Room and board for students who are enrolled at least half-time
Initially, 529 plan beneficiaries could only use the money for higher education expenses. But in 2017, the government expanded the definition of qualified expenses to include up to $10,000 annually in K-12 tuition.
UGMA & UTMA Accounts
In most states, children under the age of 18 don’t have the right to contract, so they can’t own investments. At one time, that meant parents who wanted to transfer assets to a child for their college education had to hire an attorney to establish a trust.
The UGMA and UTMA made these transfers a lot easier. The UGMA established a simple way for minors to own securities such as stocks, bonds, and mutual funds. The UTMA is similar but also allows minors to own other property types, such as real estate, fine art, patents, and royalties.
Now, parents, grandparents, and other family members can open a UGMA or UTMA custodial account at a bank or brokerage.
When they open the account, they have to provide the name and Social Security number of the minor and appoint a custodian who is in charge of managing the money in the account until the child reaches the age of majority (typically 18 or 21, depending on the state).
Differences Between 529 Plans & UGMA or UTMA Accounts
UGMA and UTMA accounts as well as 529 plans provide ways for parents and other adults to help save for a child’s education, but there are several differences.
Use of the Account
You can only use 529 plans for saving for education. You can always withdraw money from the account for other purposes. But if you don’t use the funds for qualified education expenses, you’ll face some tax consequences.
You can withdraw the amount you contribute tax-free, but the earnings portion of the distribution is taxable at your ordinary income tax rates. You’ll also owe a 10% penalty.
But you can use funds in a UGMA and UTMA for other purposes.
A 529 plan has an advantage over UGMA and UTMA accounts when it comes to tax-advantaged growth.
In a 529 plan, you don’t have to worry about paying taxes on earnings within the account since the funds grow tax-free.
In a UGMA or UTMA account, you may have to pay taxes on earnings, even if you don’t withdraw money from the account. You don’t have to worry about paying taxes if the child’s income is $1,050 or less.
Above that amount, the IRS taxes income between $1,050 and $2,100 at the child’s tax bracket and income above $2,100 at the rate for trusts and estates, which could be a lot higher than the child’s tax rate.
For 2019 through 2025, the tax brackets for trusts and estates are:
|If taxable income is:||The tax is:|
|$2,600 or below||10% of taxable income|
|$2,601 to $9,300||$260 + 24% of the amount over $2,600|
|$9,301 to $12,750||$1,868 + 35% of the amount over $9,300|
|$12,751 and above||$3,075.50 + 37% of the amount over $12,750|
Tax Filing Requirements
One challenge parents often run into with UGMA and UTMA accounts is tax return filings. With a 529 plan, the plan’s earnings don’t impact either the parent’s or child’s tax return since the account is allowed to grow tax-free.
Once you start taking money from the account, as long as you use it for qualified education expenses, you simply report those nontaxable distributions on your annual return.
UGMA and UTMA accounts can be a little more complicated. For most people, these accounts are hassle-free during the saving years, as they rarely generate enough interest and dividends to necessitate filing a tax return for the child.
If the earnings within the account are over $1,050 for the year, the parents may be able to report the child’s income on the parents’ return by attaching Form 8814 to their Form 1040.
The parents can make this election as long as the child meets all the following conditions:
- The child is under age 19 (or under age 24 and a full-time student) at the end of the year
- The child had only interest and dividend income
- The child’s gross income was less than $10,500
- The child doesn’t file a joint return with a spouse
- The child didn’t make any estimated tax payments, have federal income tax withheld, or have an overpayment from a prior year applied to the current year
The truly complicated part comes when the child needs funds from the account to pay for college expenses. At this point, they need to sell investments in the account to withdraw funds. That generates capital gains.
Parents can’t elect to report capital gains on their own returns, so they typically have to file a separate tax return for the child.
Ownership & Control of the Funds
When it comes to ensuring the child uses the money for educational purposes, 529 plans also have an advantage.
With a 529 plan, the account owner keeps control of the funds no matter the beneficiary’s age. If you save for your child’s education and your child decides not to go to college or doesn’t need all the money, you can switch the account over to another beneficiary or withdraw the money yourself (and pay taxes on the distribution).
With a UGMA or UTMA account, ownership and control over the funds go to the child once they reach the age of majority. At that point, they can spend the money however they’d like.
If the child doesn’t need the money to pay for their education, you can’t transfer the account to a different beneficiary.
Contributions & Investment Options
UGMA and UTMA accounts have advantage when it comes to the flexibility of contributions and investment options. You can fund UGMA and UTMA accounts with cash, investments, real estate, art, patents, royalties, and more. You also have wide latitude when it comes to investing assets in the account.
With a 529 plan, you can only contribute cash, and investment options are limited to those allowed by the particular plan.
You can contribute as much as you want to a 529 plan, but the amount you contribute to the plan each year goes toward your annual gift tax exclusion amount.
For 2019, the annual gift tax exclusion amount is $15,000 ($30,000 for a married couple who elect to split their gifts), meaning if you give more than that amount to any one beneficiary’s 529 plan, you must file a gift tax return that year.
However, there’s one exception. The IRS allows you to give five years of contributions all at once without paying gift taxes. For 2019, that would be $75,000 for a single person or $150,000 for a married couple.
Impact on Student Aid Eligibility
For financial aid purposes, assets in a UGMA or UTMA account are considered assets of the student. That means they have a significant impact on student aid eligibility calculations — federal financial aid formulas consider 20% of the money in a UGMA or UTMA account as money available to pay for college.
On the other hand, the Free Application for Federal Student Aid (FAFSA) treats funds in a 529 plan as assets of the parent, so it has a lower impact on financial aid eligibility. The FAFSA formula considers a maximum of 5.6% of the money in a 529 plan to be available to pay for college.
If you already have assets in a UGMA or UTMA account and you’re worried about the impact on financial aid awards, you can cash out and reinvest the proceeds into a 529 plan.
But before you do, talk to your financial advisor or accountant for help calculating the taxes you’ll pay on any capital gains.
If you want to give your child a leg up on saving, which account should you choose? It comes down to your goals. If the primary purpose of your savings is education, a 529 plan offers better tax advantages.
If you or your child aren’t sure whether they plan to use the funds for education, buying a home, or any other purpose, you can contribute to a UGMA or UTMA account.