529s vs. UTMAs and UGMAs: What's the Best Way to Save for College?
Setting aside as little as $5 a day from birth, reinvesting the earnings and allowing that initial sum to grow can make a huge difference when it comes time to pay for college. Even if your child chooses a career that doesn’t require higher education, saving money for them now can provide them a valuable financial edge in life.
But how can you best harness the power of compound interest to save for college? 529 plans, Uniform Transfers to Minors Act (UTMA) accounts and Uniform Gifts to Minors Act (UGMA) accounts are three popular investment options.
Whether you're weighing a 529 versus a UTMA or a 529 versus a UGMA, it's crucial to understand the differences between these accounts and how they’ll affect your family's financial planning.
Differences between UGMAs, UTMAs and 529s
|Account||Tax Treatment||Qualified Expenses||Change Beneficiar||Gift Tax|
|UGMA||Unearned income (e.g. dividends, interest, capital gains, etc.) up to $2,300 is subject to tax at the child’s rate, and any amount above $2,300 is subject to tax at the parent’s rate.||Funds in a UGMA can be used for any purpose after the child reaches the age of majority and takes control of the account.||UGMAs cannot be switched to a different beneficiary.||For the 2023 tax year, gifts up to $17,000 per year are exempt from gift taxes ($34,000 for married couples filing jointly).|
|UTMA||Unearned income up to $2,300 is subject to tax at the child’s rate, and any amount above $2,300 is subject to tax at the parent’s rate.||Funds in a UTMA can be used for any purpose after the child reaches the age of majority and takes control of the account.||UTMAs cannot be switched to a different beneficiary.||For the 2023 tax year, gifts up to $17,000 per year are exempt from gift taxes ($34,000 for married couples filing jointly).|
|529||Earnings and withdrawals are tax-free when used to pay for qualifying higher education expenses.||Qualifying higher education expenses include tuition, fees, books, supplies and room and board. The use of funds for non-qualifying expenses triggers income taxes and a 10% penalty on the earnings portion of the withdrawal.||529s allow you to switch beneficiaries if the new beneficiary is a family member of the original beneficiary.||For the 2023 tax year, gifts up to $17,000 per person per year are exempt from gift taxes ($34,000 for married couples filing jointly).|
A UGMA account is a custodial brokerage account created under the Uniform Gifts to Minors Act (UGMA). Enacted in 1956, the UGMA provides a way for individuals to transfer financial securities and money to minors without establishing a trust.
An adult custodian manages the UGMA account until the beneficiary reaches the age of majority — this can be 18, 21 or 25, depending on your state. Once the child reaches the age of majority, they take full control of their UGMA account.
It is important to note that UGMA accounts can only hold cash and securities such as stocks, bonds and mutual funds — they cannot contain real estate and other tangible assets.
The Uniform Transfer to Minors Act (UTMA) emerged in 1986, 30 years after the UGMA. A UTMA account is similar to a UGMA account but allows for the transfer of a wider range of assets. This includes real estate, royalties, patents and tangible personal property such as art or collectibles.
UTMA accounts are also managed by an adult custodian until the beneficiary reaches the age of majority.
A 529 plan is a tax-advantaged savings account that enables people to set money aside for future educational expenses. 529 plans are primarily used to save for college but are also often used for other educational expenses, such as private K-12 tuition.
The funds in 529 plans are not only designated for four-year universities; they can also be used for community college, vocational school, graduate school, medical school, law school and certain certificate programs.
All 50 states offer at least one 529 plan. The beneficiary’s parents or grandparents select a plan — in their home state or another state — choose a beneficiary and start saving. Plan administrators make the investment decisions.
All withdrawals must go toward qualified educational expenses to avoid taxes and penalties. Examples of qualified expenses include tuition, room and board, fees, school supplies, textbooks, computers and other qualified expenses incurred to attend an accredited college or university.
Some states offer additional tax benefits to those who invest in 529 plans. For example, Mississippi and Illinois offer state tax deductions of $10,000 for single filers or $20,000 for joint filers who contribute to 529 plans. Check with your state's tax office for more information on the rules and benefits of contributing to a 529 plan.
529s vs. UTMAs and UGMAs Pros and Cons
When deciding which account to open for a child, it’s important to review the advantages and disadvantages of the various investment accounts for kids. Depending on your situation, one account type may offer benefits that make it a far better choice than the others.
Pros and Cons of UGMA
- Can use money flexibly
- Limited tax-free growth options May decrease beneficiary's financial aid eligibility Can't change beneficiaries
- May decrease beneficiary's financial aid eligibility
- Can't change beneficiaries
UGMA accounts offer significant flexibility in terms of how the money can be used, giving the account beneficiary complete control of their assets once they reach the age of majority. This flexibility can provide the beneficiary with a beneficial financial jumpstart in life.
However, UGMAs offer less tax-free growth on unearned income than other types of accounts do. They can also potentially decrease the beneficiary’s financial aid eligibility significantly due to the account's value being counted as an asset belonging to the beneficiary. This is likely to result in a higher out-of-pocket cost for college expenses.
Pros and Cons of UTMAs
- Can use money flexibly
- Wider range of transferable assets
- Limited tax-free growth options
- May decrease beneficiary's financial aid eligibility
- Can't change beneficiaries
UTMAs offer similar benefits and drawbacks as their counterparts, UGMAs. The primary difference is that UTMAs allow for a wider range of transferable assets. This allows the beneficiary to receive additional assets and investments, such as real estate or tangible personal property.
One potential downside to both types of accounts is that it isn’t possible to change beneficiaries.
Pros and Cons of 529s
- Tax-free growth and withdrawals (when used for qualified expenses)
- Can switch beneficiaries
- Low impact on financial aid eligibility
- Restrictions on how money can be used
529 plans offer many tax benefits, such as tax-free growth and withdrawals that are free from federal income tax when used for qualified educational expenses. 529 plans also allow you to switch beneficiaries if the new beneficiary is a family member of the original beneficiary. This can provide significant flexibility for those with changing educational plans.
Additional advantages of 529 plans include a low impact on financial aid eligibility because the account's value is considered an asset of the account owner and state-level tax deductions are available in many places.
The primary disadvantage of 529 plans is that there are restrictions on how the money can be used. All withdrawals must be used for qualified educational expenses such as tuition, school supplies, computers or textbooks to avoid taxes and penalties. For those needing a wider range of uses for their funds, 529 plans may not be the best option.
Costs related to these Financial Plans
Below, we will summarize UGMA, UTMA and 529 plans and their costs.
UGMA and UTMA Plans
UGMA and UTMA accounts are typically free to open and maintain. Their only associated costs are transaction-based fees for buying or selling certain assets.
For example, you may have to pay a trading fee if you buy stocks or bonds through the account. Both E*TRADE and TD Ameritrade charge a $6.95 fee to make certain types of trades via a UGMA or UTMA account.
The cost of opening and maintaining a 529 plan varies from state to state. Most plans have an initial setup fee and annual management fees, typically assessed as a percentage of the account’s balance.
For example, Nevada's Vanguard 529 College Savings Plan has an annual expense ratio of 0.14%. This means you would pay an annual fee of $14 for an account with a $10,000 balance. Some states also offer lower-cost plans to those who invest in prepaid tuition plans or 529 savings bonds.
Annual contributions for UGMA, UTMA and 529 accounts qualify for the federal gift tax exclusion. This means you can contribute up to $17,000 per year (or $34,000 for married couples) without incurring the gift tax. Any amount above these contribution limits shall be subject to the federal gift tax.
One characteristic that sets 529 plans apart from UGMA and UTMA accounts is how taxes on withdrawals and unearned income are treated.
Withdrawals from 529 plans that you use for qualified educational expenses are tax-free, making them one of the most attractive college savings options. Any unearned income in a 529 account, such as interest or dividend income, is also free from federal income tax.
If you or your child doesn’t use the funds for qualified educational expenses, you’ll owe a 10% penalty plus income taxes on account earnings.
In terms of earnings, UGMA and UTMA accounts are subject to a more complex tax structure. The first $1,250 of unearned income is tax-free. Anything above that and below $2,300 is taxed at the kiddie tax rate (the child's rate). Any additional unearned income is taxed at the parent’s rate. Aside from this tax on unearned income, UGMA and UTMA withdrawals do not incur any other taxes.
Of particular note is the new 529 rule from the IRS, which will go into effect in 2024. This new rule allows unused 529 funds to be rolled over into a beneficiary's Roth IRA with no additional taxes or penalties. This is a relief to parents who expected excess 529 funds to be subject to the hefty 10% penalty.
Similarly, students who decide not to attend college can now easily roll their 529 funds over into a Roth IRA.
Influence of monetary aid
All three plans can potentially reduce a student’s eligibility for need-based financial aid and affect their student loans. UTMA and UGMA accounts are considered assets of the beneficiary and, therefore, have a more significant impact on financial aid eligibility than 529 plans.
The Free Application for Federal Student Aid (FAFSA) — the most common way to calculate a family’s ability to pay college expenses — assumes that 20% of a child’s assets are available to fund college.
529 plans, on the other hand, are considered assets of the parent and are assessed at a maximum rate of 5.64%. This can make a big difference when it comes to financial aid eligibility. For example, if a student has $20,000 in UGMA or UTMA accounts, FAFSA will assume that $4,000 of those funds are available to pay college expenses.
However, if that same student has $20,000 in a 529 account, FAFSA will assume that only $1,128 of those funds are available to pay for college. This often plays a significant role in determining how much need-based financial aid a family is eligible to receive.
Ability to modify the beneficiary
You can’t change the beneficiary of a UGMA or UTMA account. The assets must remain in the account until they are distributed to the designated beneficiary.
With 529 plans, however, you can change the beneficiary to another member of the same family if necessary. If you have multiple children and may have to divert funds — for instance, if one decides not to go to college — a 529 plan could be a better choice.
Which type of account is best for your child's education?
Each of these methods for funding a child’s education has its advantages and disadvantages, so it’s essential to research each option thoroughly and consult a financial advisor before making a decision.
Ultimately, the best choice for your child’s future will depend on how much flexibility you need, your tax situation and the financial aid eligibility you hope to achieve. The following sections will help you understand which situations best suit each type of account.
When a UGMA account is the best option
UGMA accounts are an attractive option for those who aren't worried about financial aid eligibility, desire maximum control over their funds and are comfortable with taxes being levied on unearned income at the account owner's tax rate (for unearned income above the $2,300 threshold).
This is especially true if you don't expect to change the beneficiary or want to risk the penalties associated with making a withdrawal from a 529 plan.
When a UTMA account is the best option
UTMA accounts are almost exactly the same as UGMA accounts. The main difference is that UTMA accounts permit a larger variety of assets to be stored in the account. This makes them a better option for those looking to include real estate investments, artwork or other non-traditional investments in their portfolio.
For example, if you have stocks and bonds but also want to invest in a piece of art for your child’s education, a UTMA account would make the most sense.
When a 529 plan is the best option
529 plans are the ideal choice for those who want to ensure that their funds are tax-free, would like the flexibility to change the beneficiary if necessary, want to minimize the impact of their savings on financial aid eligibility and intend to use the funds only for educational expenses.
They are also a great option if your state offers special tax incentives for 529 plan contributions.
UGMA vs. UTMA and 529 FAQs
Can I have both a UGMA account and a 529 plan?
You can also move funds from a UGMA or UTMA account into a 529 plan to qualify for the additional financial aid and tax benefits associated with 529s. However, any untaxed account earnings and appreciation will incur taxes. Thus, it is essential to consult a financial advisor and tax professional when considering such a move.
What happens to a UTMA account when a child turns 18?
The age of majority is typically 18 but can be 21 or older in some states. For example, the age of majority for UTMA accounts in Florida is 25. Another notable exception applies to full-time dependent students. In this case, the age of majority for UTMA accounts can be as old as 24.
How do 529 plans differ from UGMA and UTMA accounts?
However, it does incur a 10% penalty and additional taxes on any unearned income when used for non-educational expenses. UGMA and UTMA accounts, on the other hand, are always subject to taxes on any unearned income but can be used for any purpose.
UGMA and UTMA accounts also have a greater impact on financial aid eligibility than 529 plans, as they are considered your child's assets when determining the amount of money they will qualify for in grants, loans and scholarships. 529 plans are typically treated as the parent's assets and have significantly less impact on financial aid eligibility.