Updated January 2022.
Parents seeking to invest for a child’s college education have several options. These include 529 College Savings Plans, Uniform Gifts to Minors Act (UGMA) accounts, and Uniform Transfers to Minors Act (UTMA) accounts. Investors should consider the timeline they are working with and their long-term financial goals as they consider which option makes the most sense. All three accounts can be useful, but there are important distinctions between each.
529 plans are tax-advantaged education savings accounts. They are sponsored by state governments, state agencies, or educational institutions.
Funds in a 529 plan can grow tax deferred. They are not subject to income tax on income and gains. Withdrawals from a 529 plan account used for qualified education expenses are not taxed. Withdrawals not used to pay qualified expenses are subject to federal income tax and penalties.
Investments are typically limited to mutual funds, exchange-traded funds (ETFs), and money market funds. And while they are considered college savings plans, money in a 529 plan can be used to pay private elementary or high school tuition. The annual limit on K through 12 tuition is $10,000.
There is no federal contribution limit on 529 plans and parents may contribute the equivalent of five years’ worth of expenses in a single year without being subject to gift tax rules. If you do this, you must wait five years before making another contribution. States may limit contribution amounts.
For students considering need-based financial aid, money in a 529 plan is considered the parents’ asset. This reduces a student’s eligibility less than if it was considered the student’s asset. Finally, account owners can change a 529 plan’s beneficiary.
UGMA Accounts are custodial accounts opened for the benefit of a minor. The custodian (typically a parent or grandparent) controls the account, but asset transfers are irreversible. And when the beneficiary reaches adulthood (18 in most states), he or she gains control of the account.
Funds in a UGMA account can be used for any purpose without restriction.
Accounts are subject to “kiddie tax” rules. The first $1,150 (in 2022) in investment income is not taxable (it qualifies for the standard deduction). The next $1,150 is taxed at the child’s tax rate (generally 10 percent if earnings are less than $11,000). Income above that is taxed at the parents’ tax rate.
There are no formal contribution limits to UGMA accounts. Custodians who contribute more than $16,000 per year per beneficiary (or $32,000 per year per beneficiary for married couples) may be subject to gift taxes.
Money in a UGMA account belongs to the student beneficiary for financial aid consideration. As such it may negatively affect his or her ability to qualify for need-based aid.
Like a UGMA account, a UTMA account is a custodial account opened on behalf of a minor. And just like the UGMA account, assets pass to the beneficiary when he or she reaches adulthood (18 to 25 depending on the state).
The main difference between UGMA and UTMA accounts is the type of assets they can hold. UGMA accounts are limited to investment securities such as stocks, bonds, mutual funds, etc. UTMA accounts can include investment securities and hard assets, like real property and automobiles, and intangible assets such as deeds of trust.
Prior to passing to the beneficiary, the custodian can use assets in a UTMA account for any purpose, not just education expenses. The same is true after the assets pass to the beneficiary when he or she reaches adulthood.
The tax implications of a UTMA account are the same as those for a UGMA account. UTMA accounts are also subject to “kiddie tax” rules.
UTMA accounts do not have formal contribution limits, but just like UGMA accounts amounts contributed are subject to gift tax rules. Annual contributions in excess of $16,000 per year per beneficiary (or $32,000 per year per beneficiary for married couples) may be subject to gift taxes.
The financial aid implications of a UTMA account are the same as those for a UGMA account. They are considered the student’s own money. That means need-based financial aid may be negatively impacted by such accounts.
Financial Planning Considerations
The 529 plan appears to have distinct advantages over UGMA and UTMA accounts when the planning objective of the account is strictly college funding. Growth within the 529 account is shielded from taxation, and withdrawals used to pay qualified educational expenses are not taxed.
A single 529 plan can be used to save for more than one child since the named beneficiary can be changed as needed.
UGMA and UTMA accounts offer more investment flexibility and, from a financial planning perspective, can be used to transfer assets to beneficiaries without restriction. The funds need not be earmarked solely for education funding. This can give parents greater flexibility since UGMA and UTMA accounts let them transfer assets for any purpose beyond education expenses.
If a beneficiary is more likely to enter the military than attend college, then these accounts can still accomplish the custodian’s goal of transferring assets. The same is true if the beneficiary decides to attend trade school or start his or her own business.
Parents give up some tax benefits when they choose a UGMA or UTMA account. However, these accounts offer investment flexibility not available in a 529 plan.
Using More Than One Funding Vehicle
Using one type of account doesn’t preclude investors from using either (or both) of the other two. A well-designed plan using a combination of accounts may help parents optimize their education funding goals.
For example, a parent may open a 529 account because of the account’s tax benefits. However, they may not want to allocate their total savings to tuition expenses. As a result, they may fund a 529 account only to a level that is sufficient to satisfy such expenses.
They could then set other sums aside in a UGMA or UTMA account to pay expenses incidental to the beneficiary’s education expenses or for any purpose the beneficiary chooses.
Whichever route you choose, understand that we are here to help. Our College Savings Calculator can help you estimate annual tuition expenses for up to four children and run what-if scenarios based on inflation rate, current savings balances, and expected future contributions.