Are your Investments Fit for Purpose? Custodial Accounts vs. 529s

In our previous blog about the right tool for the job, we compared using a Roth IRA, and a 529 plan to save for college. This time we are looking at the pros and cons of using a UGMA and UTMA account to save for college vs. a 529 plan. We're advocates of finding the path of least resistance when it comes to investing. Depending on your financial goals, that could be a UGMA/UTMA account or a 529 plan. Here's when to use each account...

UGMA Accounts

Before deciding which type of account to open, here is a basic overview of how a UGMA account works. UGMA stands for The Uniform Gifts to Minors Act and is a type of account developed in 1956. Individuals can give assets to underage beneficiaries free of a gift tax of up to $15,000 annually and $30,000 annually per married couple. These gifts also affect a donor's lifetime gifting limits, and if the custodian dies before the minor takes control, the account becomes part of their taxable estate. UGMA accounts are custodial accounts held in the name of the minor, but a custodian controls them until the child reaches a certain age, which varies by state. The custodian is either the donor or a financial institution and uses the funds to invest in publicly traded financial assets on behalf of the minor.

You can open a UGMA account through banks or brokerages, and friends and family can make contributions to these accounts as well. There are no withdrawal penalties, and the funds can be used for any expense that benefits the minor. Once the child reaches the age of majority (18 or 21) in their state, they have complete control over the funds and can use them as they please.

There are no income tax deductions for contributions to these accounts. The accounts' earnings can be taxed either to the child or parents. If a child's unearned income (including UGMA earnings) is under $2,200 and they are no older than 19, parents can report their child's income on their tax return. The first $1,100 of the child's unearned income is tax-free, the next $1,100 is taxed at the child's tax rate, and anything exceeding $2,200 is taxed at the parent's tax rate. If the child's income exceeds $2,200, they have to file a tax return.

UGMA accounts are useful because you can pass wealth on to your children without having to go through hiring a lawyer to create a trust fund. Parents are also able to control the money until their children are young adults.

UTMA Accounts

UTMA accounts, or the Uniform Transfers to Minors Act, are an extension of UGMA accounts. UTMA accounts have the same structure and rules for contributions and taxes as UGMA accounts. The difference between these two accounts is that UTMA accounts allow for other assets besides publicly traded securities to be gifted. UTMA accounts can include money, patents, royalties, real estate, life insurance, and fine art to be gifted without a trustee. The other difference is that all assets in a UGMA account must mature before the minor reaches 18. UTMA accounts allow the investments to mature within 25 years. Also, the termination age for most states' UTMA accounts is 21, while UGMA accounts are typically 18. Another thing to keep in mind is that UTMA accounts do not exist in every state.

529 Plans

A 529 plan is a tax-advantaged investment account to save for educational expenses. You can use funds in these plans to cover everything from tuition to meal plans, vocational training, private school, and study abroad programs. Plans are opened by adults with a child as the beneficiary, and anyone can contribute. There are no annual contribution limits, but most state plans limit plan balances between $300,000-$500,000. Earnings are exempt from federal and state income taxes as long as money is withdrawn for qualified purposes, and more than 30 states provide a tax credit or incentive for contributions.

When to use a 529 plan...

1. If you are planning on applying for financial aid

Your expected family contribution (EFC) is the amount the federal government determines your family can reasonably spend on college tuition and is calculated from the information entered in your Free Application for Federal Student Aid (FAFSA). Your EFC determines the amount and type of aid that a child will receive to attend college. This number can be affected by your assets, including savings and investment accounts.

UGMA and UTMA accounts: Any funds in both of these accounts are reported on the FAFSA as an asset in the child's name. Your child's aid eligibility will be reduced by 20% of the value of their UGMA/UTMA accounts. This means if you have $10,000 in one of these plans, your child's financial aid eligibility will decrease by $2,000.

529 plans: In terms of the effect on financial aid eligibility, no tool is as good for college savings as a 529 plan. These plans are built for college savings and have the least impact on financial aid eligibility. The impact it can have on your EFC is capped at 5.64%. For example, if the parent is the account owner, and you save $10,000 in a 529 plan, your need-based eligibility would only be reduced by a maximum of $564, but likely less.

2. The primary purpose of these funds is saving for college

UGMA and UTMA accounts: Contributions are made with after-tax dollars. The contribution limit is $15,000 annually, and $30,000 per married couple without a gift tax, and these contributions apply to the donor's lifetime gifting limit. The first $1,100 of a child's unearned income is tax-free. The next $1,100 is taxed at the child's rate. Anything above $2,200 is taxed at the parents' income rate.

529 plans: Earnings in a 529 plan grow tax-free and are not taxed when the money is withdrawn to pay for college. You do not have to report contributions to a 529 plan on your federal tax return. Student loan payments and other education costs (textbooks, meal plans, etc.) are included as education expenses eligible for withdrawal. Over 30 states offer a full or partial tax deduction or credit for 529 plan contributions each year you contribute to your 529 plan. If you use the funds for education, the tax benefits of a 529 plan are unmatched!

3. You don't want your child to have control of the funds at a young age

UGMA and UTMA accounts: As soon as your child reaches the termination age, your child will have complete control over the funds. Keep in mind that the age of majority is 18 in most states, so that means your child could have unrestricted control of a hefty sum of money at 18 that they could spend on anything. When we were 18, we probably would've blown that cash quickly. Teaching your child financially healthy habits can ensure that they use this money responsibly.

529 plans: 529 plans remain in the parent's control. If you don't use the entire balance of the plan for your child's education, you can change the beneficiary without penalty to a grandchild or one of your children's siblings. You can also withdraw the funds and pay the penalty (more on that later) and give the cash to your child when you feel they're ready to use it.

4. You do your taxes on your own and aren't an accountant

UGMA and UTMA accounts: UGMA and UTMA accounts complicate your tax filing. The first $1,100 is not taxed, $1,100-$2,200 is taxed at the child's tax rate, and anything exceeding $2,200 is taxed at the parent's rate. This can complicate tax season in your household, and can become a nightmare, especially if your child has unearned income from other accounts.

529 plans: 529 plans are a great way to keep your taxes simple. Earnings in a 529 plan grow tax-free and are not taxed when the money is withdrawn to pay for college. You don't even have to report contributions to a 529 plan on your federal tax return.

Other UGMA/UTMA drawbacks Keep in mind that you can't change the beneficiary on a UGMA/UTMA account, so if one of your children becomes TikTok famous or wins the lottery and doesn't need the money, you won't be able to transfer the funds to another child. With 529 plans and other types of accounts, you can change the beneficiary with no penalty.

Another drawback is that gifts are irrevocable. You can't undo contributions to the account or withdraw the funds for any expense that doesn't benefit the child.

If either of these drawbacks makes you hesitant to open a plan, but you know your child isn't heading to college, there are other types of custodial accounts you can explore.

When to use a UGMA/UTMA account...

The critical difference between UGMA and UTMA accounts is the age of termination (usually older with a UTMA account vs. UGMA) and the type of assets. If you plan to gift real estate, art, life insurance policies, bonds, or other assets beyond stocks, you should choose a UTMA account. If you are only investing in securities, you should look at the age of termination in your state and decide from there. Beyond that, the account structure, tax rules, and situations where a UGMA/UTMA account is the right choice are the same.

1. If you want to be able to spend the money on whatever you want

UGMA and UTMA accounts: While your child is still a minor, you can use the funds for anything that benefits your child without a penalty. You can pay for sports, travel, housing, and more with a UGMA/UTMA account without worrying about paying any penalties.

529 plans: 529 plans can be used for a wide variety of education expenses beyond tuition, but there is a penalty for non-qualified withdrawals. You can withdraw funds for any reason besides education and pay income tax and a 10% penalty tax on these non-qualified withdrawals. If your child receives a scholarship, you are allowed to withdraw the scholarship amount without penalty.

2. You want flexible investments

UTMA accounts: UTMA accounts let you gift assets that 529 plans don't. Real estate, life insurance, and art are all items that can be gifted through this type of plan without setting up a trust. There is also more flexibility with the types of assets you can purchase with funds deposited in a UTMA account.

529 plans: 529 plans are invested in mutual funds, equities, bonds, and cash accounts. Typically these plans are age-based, so the mix of investments is flexible depending on when your child is going to college, but you do not have nearly the flexibility you do with a UTMA account.

3. You know your child probably isn't pursuing higher education

UGMA and UTMA accounts: These accounts are a great way to support your child's passions by giving them funds they could use to start a business, travel, and more. If you know your child isn't going to college, these accounts are one of the easiest ways to pass on wealth without setting up a trust.

529 plans: 529 plans are specifically designed to help save for education. The tax benefits are great, but there are also penalties for non-qualified expenses. If you know higher education isn't suitable for your child, you can avoid paying penalties in the future if you forgo creating a 529 plan and opt for a UGMA/UTMA account instead.

Now what...

If you are reasonably sure that your child will be going to college, a vocational program, or a private primary or high school, a 529 plan is the better option. The tax advantages and effects on financial aid eligibility are unmatched when paying for education. Keep in mind that even if your child doesn't use the funds for college, they can transfer the balance of the 529 plan to a sibling or their child without any penalty and still reap the tax benefits.

On the other hand, if you are confident that your child will not attend college, the flexibility of a UGMA or UTMA account could be better for your child. They can use these funds to do anything once they reach the majority age, and you can pass on wealth without creating trust. Be sure to educate your child on how to use the money responsibly before they take control.

If you are unsure what path your child will take, or if you plan to help them avoid student debt and help them buy a house or start their own business one day, then you can open up a 529 plan AND a UGMA or UTMA account to reap the benefits of passing on wealth and paying for college.

With both types of accounts, starting to save early will have the most impact. Compounding returns will make your money work for you. Even small contributions will grow over time to change your child's life! So do some more research and decide what plan is right for you so you can get started saving today.