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Published: Mar 17, 2021 11 min read
Two baseball caps upside down, one fills with cash and one without.
Kiersten Essenpreis for Money

When Ksenia Yudina launched a startup that aimed to offer parents a simple, affordable and accessible way to save for college, she initially focused on 529 college savings plans.

The plans are the go-to choice among financial planners advising clients on saving for a child's college bills. Yet last year, after offering 529 plans through her company, UNest, Yudina found those plans weren't the go-to choice for her clients. UNest's users wanted to save for their children's futures, but they weren't sure they wanted to save exclusively for college, and they didn't want to lock their money up in an account that would penalize them for spending on something else.

So UNest pivoted, instead choosing to offer Unified Transfer to Minors Act (UTMA) accounts, which have far more flexible spending options than 529 college savings plans, where you'll get hit with a penalty if you spend on unapproved items. The company's experience highlights a common question parents have when it comes to planning for their child’s future: where should we park our savings?

The standard advice from financial planners is that if you’re certain you want to use the money you’re saving for higher education, then it’s hard to beat a 529 college savings plan. But the pandemic has only underscored an already growing sense of skepticism over rising college prices and the value of a four-year degree, and many parents want more options when it comes to their hard-earned savings.

Alongside UNest, roboadvisor Acorns and startup EarlyBird also launched custodial accounts in the past year. The companies' internal research suggests that parents prefer the flexibility associated with custodial accounts, commonly called UTMA or UGMA accounts.

UTMAs vs. 529 plans: Why are 529s typically preferred for college savings?

First, a bit of background: 529 college savings plans are tax-advantaged savings accounts designed specifically for higher education. Your money grows tax free and you don’t pay any taxes on the earnings if you use the money to pay for qualified expenses. Those expenses include tuition, fees, room and board, and educational materials like computers or textbooks.

Custodial accounts — officially the Unified Transfer to Minors Act (UTMA) accounts or Uniform Gifts to Minors Act (UGMA) accounts — don’t offer the same expansive tax benefit, but they do offer far more flexibility, both in the variety of investments you can put your money in and in the expenses you can use it for.

With these accounts, the first $1,050 in investment earnings is tax-free and the next $1,050 is taxed at 10%. But after that, earnings will be taxed at the parents' tax rate. That means roughly a third of your investment earnings above $2,100 could have to be paid back to the government.

Still, you can spend the remaining earnings on anything that benefits the child: college, a down payment on a home, a wedding. When the child hits the "age of maturity" on the account, typically 18 or 21 (depending on the state), the entire balance of the account is transferred to them, and they can do whatever they want with it.

So 529 plans score a point for being entirely tax free, but one of the biggest reasons that planners recommend them over any other tool for college savings relates to financial aid.

Most people tend to know that your assets are captured on financial aid applications, says Roger Young, a senior financial planner with T. Rowe Price. But they often don’t understand how different types of assets are counted.

With a 529 plan, that’s considered the parent’s asset, so the federal financial aid formula essentially counts 5.64% of it as money that can be put toward paying college bills, Young says. An UTMA/UGMA, though, is considered the child’s asset, even if the child hasn’t reached the age for maturity for the account yet. That means 20% of the total asset is considered money that could be spent on college.

In simpler terms: 529 plans are treated more favorably in the government’s accounting of whether you’ll qualify for any financial aid.

Young says he typically only recommends UTMA/UGMA accounts over a 529 plan if families check a handful of boxes: They want more flexible spending options, but they're not worried about how their child might use the money. They want to teach their kid about investing and they're not worried about triggering the kiddie tax — a rule that requires some taxes on investments owned by individuals under 19. And finally, if they don't expect to be considered for any need-based financial aid when applying to college.

Steven Fox, founder of Next Gen Financial Planning in San Deigo, Calif., says that parents often overestimate the penalty if they end up wanting to spend 529 money on items outside of higher education.

They think they'll lose everything in the account, but they'll just have to pay taxes on the earnings, plus a 10% fee. It's also very easy to simply transfer the account to another family member if one child doesn't end up needing it for college, he says. The funds can also be used for graduate and many trade schools, offering further flexibility.

Some parents still prioritize flexibility offered in UTMA/UGMAs

A 2018 survey from Sallie Mae found that among parents who weren't saving for college, 18% said they weren't because they prioritized other savings while 21% said it was because they weren't sure of the best options to save. The most common reason, though, was that they simply didn't have enough money to save for college.

For UNest, parents' preference is clear. When the company switched to offering custodial accounts, it allowed existing customers the choice of whether to opt in. The vast majority of them did, Yudina says. The company offered customers who switched from a 529 to an UTMA a $10 bonus, which covered most of the customers' 10% penalty for withdrawing money from a 529 plan without spending it on college expenses.

"When there’s uncertainty, people value flexibility," she says, adding that parents weren't sure what college might cost years from now or whether they'd want to direct their savings to a home or a car instead of college.

When Acorns was researching a product to help parents save, its findings were similar to UNest's. Parents really valued the idea of being able to spend the money on anything that would benefit the child, says Kennedy Reynolds, chief brand officer at Acorns.

Nearly nine months into offering the accounts, Acorns has roughly 190,000 clients on its $5-a-month Acorns Family plan, which gives clients access to UTMA/UGMA accounts, as well as the full suite of Acorns products. Forty percent of clients with custodial accounts earn under $50,000 a year, Reynolds says.

Plenty of families today are considering paths that don’t include traditional higher education, in part because of its high cost, Kennedy says. Offering custodial accounts allows the company to help families save for college if that’s their goal without preordaining their path if it isn’t, she says.

And for families who are sure their child will attend college, parents can split their savings between 529 account and an UTMA accounts, she says.

Whether you’re weighing if you should invest in an UTMA or a 529 (or both), keep these tips in mind:

Take care of yourself first: Sometimes, one of the biggest barriers to saving for college for Fox's clients is a barrier he makes them build: ensuring that they're saving enough for other financial priorities first, he says.

Nearly every financial planner will tell you the same. You should pay off high-interest debt, have an emergency fund and ensure you're on track with your retirement savings before you invest a lot of energy in saving for your children's future.

Be realistic: Don’t avoid saving for college because you think your son or daughter will get a scholarship or financial aid. While the vast majority of students do get some kind of financial aid, hardly anyone gets a full ride. Your savings will help pay for whatever's left over after scholarships and grants.

On the same note, don’t avoid saving as an attempt to maximize your chances of qualifying for financial aid, Young says. “You don’t want to be in a position where your savings are weak compared to your income level."

Build good habits: Both UNest and Acorns encourage users to set up recurring deposits, even if they are modest amounts. For many, it's a lot easier to break large goals down into smaller, more approachable chunks.

"What generates the right type of returns is consistency," Yudina says.

Ask for help: UNest and Acorns Early, the name of Acorns' custodial accounts, each make it easy to accept gifts from friends and family members into your child’s account. Newcomer EarlyBird even pairs that with a video message from the giver.

College savings plans also increasingly encourage contributions to help parents’ savings go further. CollegeBacker, an app aimed at making college savings easier, says a third of its assets come from gifts.

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