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529 plan or UTMA. Which is a better choice?

A few weeks ago, I wrote about the high cost of college education and the pros and cons of using cash value life insurance to help fund future college costs.  Other more common alternative savings vehicles that can be used to save for college are with UTMA/UGMA accounts or 529 Savings Plans.  What are the differences between these two options and which is the better choice?

What are UTMA/UGMA Accounts?

UGMA stands for Uniform Gift to Minors Act and UTMA stands for the Uniform Transfer to Minors Act.  Both savings vehicles are called “custodial” accounts as the parents act as the custodian of the account and manages it until their children become adults.  The custodian names who the beneficiary will be and determines at what age the child will receive the money.  With an UGMA the limit (Age of Termination) is 18 and with an UTMA is 21.   In some states like California the UTMA age limit can be extended to age 25.  In terms of what assets can be placed in these account, only basic assets like cash, stocks, bonds, and insurance can be placed into an UGMA.   A broader range of assets can be placed into an UTMA such as real estate and art.    Parents can contribute as much as they wish annually into an UTMA / UGMA.  However, because the contribution is considered a gift any amount greater than $15,000 annually, or $30,000 if married filing jointly, will be subject to federal gift tax guidelines.  From a taxation standpoint, any interest earned within an UGMA/UTMA are taxable in the year that they occur.  Because custodial accounts are considered to be the child’s asset, they will be counted against any financial aid application and 20% of the account balance will be considered available each year for college expenses.   When the child reaches the age of termination, any unused amounts in the custodial account must be distributed to the child who can use the assets for any purpose they wish.

What is a 529 Plan? 

529 Plans are named after the Internal Revenue Code that governs this plan:  IRC Section 529.  529 Plans are qualified tuition programs that allow parents to save for their children’s college (and high school up to $10,000 annually) education on a tax-qualified basis.   A 529 Plan account is owned by the parent but must name a specific child beneficiary for the account.  Parents can generally contribute as much as they wish annually into a 529 plan within certain limits.  (The balance in the 529 plan cannot exceed the total expected cost of the child’s college expenses.)  

How Does Funding for a 529 Plan Work? 

Contributions to a 529 Plan are considered a gift and any amount greater than $15,000 annually or $30,000 if married filing jointly will be subject to federal gift tax guidelines.  Some states (California is not one of them) will allow parents to deduct their 529 plan contribution from their state taxes up to $5,000 per year for an individual and $10,000 if married filing jointly.  529 Plans are tax-deferred accounts so interest growth is not taxable until the money is withdrawn.  In addition, any money withdrawn for education expenses will not be taxed at all and the interest growth is considered tax-free income.   Any unused money does not get transferred to the beneficiary but stays with the parent.  The parents can decide to use the funds themselves.  However, money withdrawn for non-college expenses will be taxed as ordinary income plus a 10% penalty.    Parents can also choose to keep the money in the 529 plan and provide it to other family members who may decide to go to college later on. This is done by changing the beneficiary from the original child to another family member (siblings, nieces, nephews, cousin, etc.).  From a financial aid application standpoint, 529 Plans are considered assets of the parents with 5.64% of the total balance considered being available each year for college expenses.   

Which is Better?

Prior to the creation of 529 Plans in 1996, UTMA / UGMA’s were a reasonable way to save for children’s education.  These custodial accounts provided parents with a number of benefits such as being able to set aside assets for a specific individual, assets staying under parental custodianship until the child reached adulthood, and receiving certain tax benefits (a portion of the interest earned was taxed at the child’s lower tax rate).  The main disadvantage with UTMA/UGMA’s were that the parents lost complete control of the assets when the child reached the age of termination and the assets were transferred entirely to the adult child.  

529 Plans on the other hand provide parents with certain advantages over custodial account:  tax advantages, no loss of control of the funds, transferability of 529 plan to another family member, and lower impact to financial aid eligibility.  So, if the goal is to save money for your children’s education, 529 Plans are the better choice.

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This content is developed from sources believed to be providing accurate information, and provided by Attune Financial Planning.  Please consult your financial, legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information only.