Planning for your child’s future can be a scary proposition. By 2040, the cost of an in-state, four-year public university could cost as much as $270,000 per year.[1] The sticker shock leaves parents questioning “How on earth are we going to pay for that, and where do we even start?” However, college isn’t the only thing parents want to help their children save for in the future, buying a house, paying for a wedding, and potentially starting a business, are all examples of things that parents often consider putting money away for on their child’s behalf. So what is the best way to start, and what kind of savings vehicle do you utilize to save for these goals?
The two account types that parents typically look to are 529 college savings plans, and custodial accounts governed by the Uniform Gift to Minors Act or Uniform Transfer to Minors Act (UGMA/UTMA). Understanding the distinction between these two options is crucial, and using the wrong one to fund future goals can be costly.
529 Plans
A 529 plan is a tax-advantaged savings account specifically designed for education expenses. Some of the benefits include:
Tax Benefits: Contributions are made with after-tax dollars, and grow on a tax-deferred basis. Withdrawals for qualified education expenses are then tax-free. Some states also offer additional tax benefits for making contributions to these accounts. For example, if you made $10,000 in contributions to a 529 plan, and the funds grew to $30,000 by the time your child attends college, you would avoid paying taxes on the $20,000 in gains.
Control: The account owner retains control over the funds, including investment decisions and distributions.
Transferability: The beneficiary of a 529 plan can be changed at any time, for any reason, and without tax consequences, the new beneficiary is a family member. A family member includes a child, stepchild, foster child, adopted child, sibling, parent, aunt, uncle, or first cousin.[2] So if one child decides not to attend college, the funds can be shifted to their sibling, or another beneficiary to help fund their education instead.
Flexibility: While primarily for education, recent changes allow up to $10,000 to be used for K-12 tuition each year, as well as certain other educational expenses.
Roth IRA Rollover: Recent rule changes currently permit rolling over up to $35,000 of the unused funds to a Roth IRA under certain circumstances. For example, if the beneficiary of a 529 plan earns $7,000 per year, and they don’t plan to use the funds for education, they could roll over that amount each year to a Roth IRA in their name. This assumes certain requirements have been met. (The beneficiary must have earned income in the amount of the rollover, the plan must be 15 years old, any contributions made in the last 5 years can’t be rolled over, and the rollover amount can’t exceed annual contribution limits)[3]
Contribution Limits: High aggregate limits, varying by state, often exceeding $500,000.
Financial Aid Impact and Grandparent Loopholes: The 529 plan is considered a parental asset if owned by a parent, having a relatively low impact on financial aid calculations. If the accounts are owned by a grandparent, they are excluded from the financial aid calculations altogether. [4] Parental assets, such as a parent owned 529 plan, are counted at 5.64% of the total value for student aid reduction.
Taxes and Penalties: The downside to utilizing a 529 Plan is that if the child doesn’t use the funds for qualifying educational expenses, there is no other beneficiary that can utilize the funds, and they have used up the $35,000 lifetime Roth IRA rollover limit, then the earnings would be subject to income taxes and a 10% penalty. [5]
Custodial Accounts (UGMA/UTMA)
Custodial accounts are established under the Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA), allowing assets to be held in a minor's name, managed by a custodian until the child reaches the age of majority. Some of the benefits are:
Flexibility: Funds can be used for any purpose benefiting the minor, and are not limited to education.
Irrevocable Gifts: Contributions are irrevocable and become the property of the minor upon reaching adulthood. So once the child turns 18 or 21 years old, depending on the state, they would gain full control of the assets.
Tax Considerations: Earnings may be subject to the "kiddie tax," where unearned income over a certain threshold is taxed at the parent's rate.
Financial Aid Impact: Custodial accounts are considered a student asset, which can have a significant impact on financial aid eligibility as they are more heavily factored into financial aid calculations than parental assets. Student assets are counted at 20% of the value towards financial aid reduction vs. 5.64% for parental assets such as a parent owned 529 plan.
Choosing Between a 529 Plan and a Custodial Account
When deciding between these two options, it’s important to think about what your goal is for the funds:
Purpose: If the primary goal is funding education, a 529 plan's tax advantages are beneficial. For broader financial support, and non-educational goals, a custodial account offers more flexibility.
Control and Ownership: 529 plans allow the donor to maintain control over the funds, whereas custodial accounts transfer control to the beneficiary upon reaching the age of majority. This can be concerning for parents, who often don’t want to put large sums of money in the hands of their 18 or 21 year old children.
Tax Implications: 529 plans provide tax-free growth, and tax-free withdrawals for qualified educational expenses. While custodial accounts may incur taxes on earnings.
Financial Aid Considerations: Assets in custodial accounts can more significantly affect financial aid eligibility compared to 529 plans.[6]
Both 529 plans and custodial accounts have unique advantages and limitations. Aligning your choice of savings vehicle with your financial goals, and considering factors such as tax implications, control of the funds, and their intended use, will help you make the best decision for your child's future.
Disclaimer: The opinions voiced in this article are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.
Prior to investing in a 529 Plan investors should consider whether the investor's or designated beneficiary's home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state's qualified tuition program. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary. Please consult with your tax advisor before investing.
[1] https://www.calculator.net/college-cost-calculator.html?todaycost=29%2C910&useaverage=29910&costincrease=5&collegelength=4&savingpercent=0&balancenow=0&returnrate=5&interesttaxrate=25&startin=15&x=Calculate
[2] https://www.irs.gov/newsroom/529-plans-questions-and-answers#:~:text=Q.%20Can%20I%20change%20the,another%20member%20of%20the%20family.
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