The Difference Between 529 College Savings Plans and UGMA/UTMA Custodial Accounts

As parents we want to give our kids the best possible head start financially. For many of us that means turning to investment vehicles designed specifically with minors in mind; two of the most popular are the 529 Education Savings plan, most commonly referred to simply as the 529 plan, and the saving account provided by the Uniform Gifts to Minors Act (UGMA)/Uniform Transfers to Minors Act (UTMA). Both of these options offer ways for parents to begin saving for their children and for the accounts to eventually transfer ownership to the designee. In today’s post we explore the pros, cons, and specific functions of these two popular accounts to help you choose the right one for your child.

How does the 529 College Savings Plan work?

Perhaps the more well-known of the plans discussed here, the 529 college savings plan is a savings account designed by the IRS specifically to help parents begin saving for their child’s college costs. Used in all fifty states, the 529 plan is a tax-advantaged plan sponsored by state agencies and educational institutions. There are generally two types of variants to the 529: (1) prepaid tuition plans that allow plan sponsors to lock in the current cost of tuition at a participating University in their state and (2) a more general college savings plan that allows users to use funds to pay for tuition at any university or college in the country, not just participating state institutions. The first option, a prepaid tuition plan, is typically backed by the participating University. Plan sponsors purchase units or credits at the University in advance for the student. The second, more general option allows the student to choose an out-of-state higher education institution. This option however is riskier than purchasing prepaid tuition units as the fund is comprised of investments like mutual funds, bonds, and money market accounts. Like similar savings plans, this variant in the 529 is not backed by state agencies or educational institutions, and is subject to market fluctuations.

What about a savings plan through UGMA/UTMA?

UGMA/UTMA accounts, often called ‘custodial-accounts’, are quite different from 529 savings plans, despite both serving as savings vehicles for minors. The UGMA/UTMA is a vehicle used to create a general savings plan for an underage person with the funds available for withdrawal upon the minor reaching a certain age. Funds can be withdrawn for a variety of reasons, i.e. the money is not limited to covering college tuition. These funds can be used to cover the costs of expensive benchmarks young people face like the cost of buying a car, a down payment for a house or to cover wedding costs. It’s important to note that once the minor turns 18 or 21, the specific age is determined by state, the minor will have full access to the funds and can do whatever he or she pleases with the money. The minor could just as easily squander the funds as use it for a responsible need. As is common with custodial accounts, money invested goes through the “kiddie tax”. This means invested funds are not taxed at the parent’s income level. Instead a portion of the funds – up to $1050 as of 2016 – is not taxed at all, subsequent funds are taxed at a relatively low ‘kid tax rate’. Parents can often use this investment vehicle to lower their taxable income.

So what are the differences?

What’s the difference?529 College Savings PlanUGMA/UTMA
Custodial Account

Who can set the account up?Anyone can contribute to a child’s 529 college savings plan, including parents, grandparents, aunts, uncles, friends, etc.Any adult can set up a custodial account for any child under age 18.

How can the funds be used?There are two variants to the 529 plan: a prepaid tuition plan and a general college savings plan. The first allows the parent to ‘pre-purchase’ credits or units of tuition at current market prices from local participating state universities and colleges. The latter allows parents to more generally save funds that can be used for any college or university in the U.S. Unlike custodial plans, 529 college plans are controlled solely by the parent in entirety.The fund can be used to cover any costs associated with the child. Once the child turns 18 or 21, depending on state law, the child gains full access and control of the account.

How is the plan invested?Prepaid tuition plans are not invested. Rather, they purchase predetermined tuition units from an arrangement made by the State and local participating universities and colleges.
General college savings plans are comprised of mutual funds, stocks, and bonds. Often the risk ratio is adjusted the closer the child gets to college-age.Primarily through stocks, bonds, mutual funds. Due to their custodial and protective nature, these plans are not permitted ownership of higher risk investments like stock options or buying on margin.

How is the plan taxed?Contributions made from residents in the state the plan originated may be eligible for state tax deductions. This is not the case for people no longer living in the same state as the plan origination. Some states even offer matching for contributions, similar to how 401(k)’s work. Additionally, there is no income tax upon withdrawal as long as the funds are used for qualified educational expenses.As of 2016, up to $1050 of the account earnings are tax free. The next $1050 will be taxed at the ‘kid rate’ of 10% federal tax. Any further earnings will be taxed at the parent or guardians tax rate.

How does each plan affect financial aid qualification?Funds are considered part of the parents assets and not the students. This means financial aid qualification is more likely than in custodial accounts.Custodial accounts are considered an asset of the child they are set up for. Therefore, they are counted heavily against financial aid. Approximately 20% of these assets will be expected to be used toward funding a student’s education in any given year.

Treatment of unused fundsIf your student decides not to attend college or receives a scholarship, the fund can be transferred to another beneficiary for higher education purposes like to a younger sibling or for a parent to finish schooling.Once the participant reaches age 18 or 21, depending on statutes by state, the child will have full access to use the funds however he or she wants

Have additional questions on what savings plan is best suited to you and your family? Our experienced financial advisors at TrueNorth Wealth are more than happy to help you create a personalized financial plan for your family.