What's the Best Way to Save for College? The Pros and Cons of 529s vs. UTMA Accounts
Rankings as of Jun 30, 2020.
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When Albert Einstein said that compound interest is the universe’s most powerful force, he wasn’t kidding.
Set aside $5 a day, every day, beginning when your baby is born, and invest it at 8%. By age 18, your child will have about $73,000 put aside for college expenses — substantially more than the average $18,000 that families save for college, according to a 2018 report by lender Sallie Mae. Assuming no withdrawals for college expenses, by age 65 that child will have a $4 million cushion to pad her retirement — again, much more than the $17,000 that the average American has saved by that point in life.
Of course, to reach those numbers, you’ll have to set aside $5 a day. Making that easier is the goal of Acorns Early, a product launching on Tuesday from Acorns, a financial services firm that’s based in Irvine, Calif. and specializes in micro-investing.
A flat, monthly $5 fee gets consumers a subscription to the product suite that contains Acorns Early, as well as other investment and banking offerings. As a nod to economic fallout from the coronavirus pandemic, parents of babies born in 2020 don’t pay the fee until their child turns 18. Money goes from the subscriber’s bank account to a portfolio of aggressive, stock-focused exchange-traded funds, an investment type that generally involves very low management fees.
Any family member or friend can contribute to a child’s investment fund. Acorns also has a long list of corporate partners, from Apple to Disney+ and HelloFresh, who will chip in small amounts when parents do business with them.
Though parents typically start and continue the investment, the accumulated money within an Acorns Early account doesn’t actually belong to them. It’s a gift to the child under the Unified Transfer to Minors Act, or UTMA. Parents (or other adult subscribers) act as custodians until the child is an adult. They can spend money from the account for the child’s benefit—on music lessons or summer camp, for instance. At age 18, 21, or 25, depending on the state, the money in the account belongs to the child outright.
But before you leap at the opportunity to set up an UTMA for your own bundle of joy, however, consider your goals, and whether an UTMA account is the right vehicle to help you accomplish them. UTMA accounts are just one way to invest on a child’s behalf. A 529 plan is another popular choice, and the two have distinctly different pluses and minuses.
UTMA: Flexible spending but no tax advantages
An UTMA offers unrivaled flexibility. Parents can put as much money as they like in an UTMA account and make decisions about how to invest it. They can spend the funds in ways that benefit the child, a list that can include anything from riding lessons to college tuition.
Despite the flexibility an UTMA account offers, however, it comes with three significant drawbacks. First, an UTMA comes with few tax advantages. There’s no tax on the first $1,050 of investment returns. The next $1,050 is taxed at 10%. Beyond that, UTMA accounts pay taxes at the parents’ rate, which is almost certainly higher than the child’s.
But though it’s taxed at the parents’ rate, an UTMA counts as the child’s asset when it comes to qualifying for college financial aid. The FAFSA, the most common calculator of a family’s ability to pay college expenses, assumes that 20% of a child’s assets are available to fund college, compared with just over 5% of a parent’s assets.
When the beneficiary reaches the age of majority—age 18, 21, or 25, depending on your state—the money in an UTMA account becomes that person’s property. Parents can ask, beg, or cajole their adult offspring to reinvest the funds, but have no legal way to prevent kids from blowing the money at a local bar.
None of those things are a problem for Dennis Nolte, a financial planner in Oviedo, Florida. He started an UTMA account for his daughter a year ago. Now Jessica, age 17, has two part-time jobs, and her father matches whatever she puts in her account.
“We’ll use it for a lot of purposes until she’s 25,” Nolte says. The account helps him teach his daughter about investment decisions, and he appreciates the flexibility it offers, saying that the account will likely fund a trip to Europe for Jessica after she graduates from high school. The family earns too much money to expect college financial aid, he adds.
Will Jessica use the money responsibly when it’s hers? Nolte says he isn’t worried, because the family plans to spend most of the UTMA funds before that point.
529 plans: Tax benefits but fewer spending options
A 529 plan isn’t as flexible as an UTMA account, but it offers advantages around taxes and financial aid. All 50 states offer at least one 529 plan. Parents or grandparents pick one of those plans—it doesn’t have to be the one in your home state—choose a beneficiary, and start saving. Plan administrators make the investment choices.
The money in a 529 plan can only be used to pay for tuition, fees, room and board, textbooks, computers, and other qualified expenses of attending an accredited college or university. Use the money for other purposes, and you’ll owe a 10% penalty plus income taxes on account earnings.
If there’s money left in the account when the beneficiary graduates from college, it can fund graduate school expenses, or parents can choose a second beneficiary.
Those conditions are much stricter than the ones the UTMA imposes. In exchange for accepting those limitations, however, families get two big benefits. First, the money in a 529 plan grows tax free. As long as you use the money to pay qualified educational expenses, you’ll never owe income tax on account earnings. Needless to say, you can’t start saving for your child’s retirement with a 529, like you could with an UTMA.
Second, a 529 plan counts as a parental asset when families apply for college financial aid. Just over 5% of total parental assets (excluding certain protected categories like retirement accounts) are considered available to pay for college.
On balance, “I think it would be much better to open a 529 plan with the parent as custodian,” says David Haas, a financial planner in Franklin Lakes, New Jersey. Parents could also plan to spend down an UTMA, as Nolte will, or combine a 529 plan with a Roth IRA, to save for both college expenses and a child’s far-off retirement.
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