Kevin Michels, CFP®, EA
If you’re thinking about starting a college education fund to help pay for a child’s, grandchild’s, or somebody else’s college education you have quite a few options to choose from.
However, two of the most popular options are Section 529 plans and UTMAs (Uniform Transfer to Minors Act).
Both accounts have benefits and drawbacks and the decision on which one to use should depend on your own personal situation as well as the circumstances of the intended beneficiary. When deciding which account to use to accomplish your goal I find it helpful to compare the following characteristics:
- Tax Benefits
- Flexibility (what the beneficiary can use the funds for)
- Portability (the ability to change beneficiaries)
- Impact on Financial Aid
529 plans have exploded in the past decade primarily due to the outstanding tax benefits you receive by paying qualified college expenses through them. Each state sponsors their own 529 plan(s), and although you’re not beholden to your own state’s plan, in some cases you receive additional tax benefits for using them.
If used correctly, 529 plans are taxed similarly to a Roth IRA. All contributions are made with after-tax money. While the money is invested within the 529 plan earnings and growth are tax-deferred. If used for qualified college expenses, withdrawals from 529 plans are also tax-free.
In addition to tax-free withdrawals you may be able to receive a state tax credit or deduction for making contributions to your own state’s plan or even another state’s plan. For example, our clients in Utah are eligible to receive a small state tax credit of up to $190 per beneficiary (for a married filing jointly couple) by contributing to Utah’s 529 plan. Our clients in Arizona are actually eligible to receive up to a $4,000 state tax deduction regardless of the 529 plan they contribute to!
Unlike 529 plans, UTMAs are not tax efficient. A UTMA is a taxable account meaning all contributions are made with after-tax dollars and all interest, dividends, and capital gains are taxed in the year they occur. And thanks to the Kiddie Tax that was introduced in 1986, any investment income in excess of $2,100 is taxed at the parent’s rate instead of the child’s. If you’ve saved a lot of money over a long period of time in a UTMA it can result in a large tax bill when it comes time to sell funds and pay tuition due to built-in capital gains.
If you want to enjoy the tax benefits associated with 529 plans then you have to ensure the funds are used for qualified educational expenses. If funds are used for anything other than qualified expenses the earnings portion of the withdrawal will be penalized 10% and fully taxable. Qualified educational expenses include tuition and fees for college, university, vocational school, or other postsecondary educational institution. It can also be used for room and board but can’t exceed the school’s cost of attendance for federal aid calculations. Books, computers, and school supplies also count as qualified expenses.
The most beneficial aspect of a UTMA is the flexibility you enjoy with what the money can be spent on. UTMAs aren’t specifically designed for college education so the beneficiaries can use the money whenever they want on whatever they want. If you want to support a child or grandchild with any venture they decide to take on, whether it be college or starting a business, then the flexibility of a UTMA is definitely something to consider.
As the custodian of the 529 plan you can change the beneficiary of the account at any time to whomever you want, including yourself. However, keep in mind, that if you change the beneficiary to someone who is not a relative of the original beneficiary funds will be penalized upon withdrawal.
Money contributed to a UTMA is considered an irrevocable gift, meaning the moment that money hits the account it is the property of the beneficiary. As the custodian of the account you have no power or authority to change the beneficiary or take the money back.
The custodian of 529 plans always retains control of the assets. The custodian is in control of how the account is invested, and the timing and amount of withdrawals.
The custodian of the UTMA retains control of the investment and withdrawal decision until the beneficiary reaches either age 18 or 21 (depending on the state you live in). Once the beneficiary reaches either age 18 or 21 they have unlimited control and access to the funds. In some cases, this can be a huge drawback and a major reason to stay away from UTMAs. If you are worried that the beneficiary will use the money on something other than the intended purpose (school, a business, or whatever it may be), then a UTMA is probably not your best bet.
Impact on Financial Aid
Approval of financial aid depends on income and assets of both the individual applying for federal financial aid and their parents (if they are considered a dependent). The value of assets has less of an impact on the eligibility of financial aid when owned by the parent versus being owned by the individual applying for financial aid. Another benefit of a 529 plan, is that the account is considered an asset of the parent instead of the individuals when applying for financial aid.
Since the money contributed to a UTMA is considered an irrevocable gift, the UTMA is considered an asset of the child instead of the parent for federal financial aid purposes. If you are a high-earning individual or a dependent of a high-earning individual this is a non-factor simply because you wouldn’t qualify for financial aid anyway. However, if you find yourself in a situation where you could qualify for financial aid but you are the beneficiary of a UTMA account is may make sense to transfer the funds from the UTMA to a 529 plan.
The Bottom Line
Both 529 plans and UTMAs have their own unique benefits and drawbacks. Overall, if you are certain your beneficiary will be using the funds for college expenses then a 529 plan is perhaps the better option. If used correctly, it’s more tax-efficient than a UTMA, can be transferred to another beneficiary, allows you to retain control, and is a better asset to own for financial aid purposes.
However, if you want to support your beneficiary in any endeavor they choose to pursue and have reason to believe that may not be a college education, then the flexibility of a UTMA may be a better option.
Also, keep in mind, there are other options out there including using a Roth IRA, a Coverdell Savings Account, pre-paid tuition, or simply just accumulating money in a savings account and gifting to your beneficiaries whenever you choose.
In any case, with whatever option you are considering make sure you take into account the tax benefits, flexibility on use of the funds, portability of beneficiaries, control of investments and withdrawals, and the impact your gift will have on financial aid.
For more information on 529 plans and UTMA accounts visit savingforcollege.com.