When planning for your child’s financial future, you may come across information about two well-known investment vehicles – 529 plans and Custodial/UTMA (Uniform Transfers to Minors) Accounts. Both options offer unique benefits, but serve different purposes and come with specific advantages and limitations. Choosing what’s best for your family depends on your financial goals, priorities and how you envision your child using the funds.
Purpose
Align your savings strategy with your goals. Is your priority giving your child an outstanding education, or do you want a more flexible approach? Ask your accountant how and when to use 529 plans and UTMAs to decide which one makes more sense for your needs.
- 529 plan: Designed specifically for education, 529 plans are ideal for covering college expenses and, in some cases, K-12 schools. They offer substantial tax benefits if education is your primary savings goal. Qualified expenses include tuition, textbooks and housing.
- UTMA: Unlike 529 plans, UTMAs are custodial accounts that allow adults to transfer assets to minors for any purpose, such as education, housing, a car or even starting a business. They’re a flexible option if your goals extend beyond education.
Ownership and Control
The account ownership and decision-making authority of your chosen investment vehicle will influence the funds’ management and when your child can use the money you’ve set aside.
- 529 plan: The contributor – typically a parent or grandparent – retains control of the funds in a 529 plan. As the beneficiary, the child has no say in how the money gets used, and the account owner can transfer the funds to another family member if the original beneficiary doesn’t need them.
- UTMA: In a UTMA, the child legally owns the assets, but a custodian manages the account until the child reaches the age of majority (18 to 21, depending on the state). Then, they gain full control of the account and can use the funds for any purpose – even if it’s not what you originally intended.
Tax Benefits
529 plans and UTMAs have tax advantages and limitations that may affect how your money grows over time.
- 529 plan: Contributions are not tax-deductible at the federal level, though some states offer deductions or credits. Investment growth is tax-deferred, and withdrawals are tax-free if used for qualified education expenses. Non-educational withdrawals incur income tax on earnings plus a 10% penalty.
- UTMA: Compared to 529 plans, UTMAs have no special tax advantages. Income and gains within the account are subject to an annual tax, which can reduce compounding growth. The IRS taxes unearned income over a specific threshold at the parent’s rate, according to the “kiddie tax” rules.
Flexibility
If you plan to invest, you must know the rules and restrictions governing the use of the funds.
- 529 plan: You and your child must use the savings for qualified education expenses, including college tuition, room and board, books, K-12 private tuition (up to $10,000 per year) and student loans (up to $10,000 lifetime). Taxes and penalties apply if you use the funds for non-educational purposes.
- UTMA: UTMAs offer unmatched flexibility. Once the child gains control, they can use the funds for anything – school, housing, a car or even a vacation. However, this lack of restrictions can be a disadvantage if they do not spend wisely.
Impact on Financial Aid
Saving for your child’s future shouldn’t unintentionally hinder their financial aid eligibility. However, 529 plans and UTMAs can affect how much assistance they qualify for.
- 529 plan: Treated as a parental asset when owned by a parent, a 529 plan has a smaller impact on financial aid eligibility (up to 5.6% of the account’s value).
- UTMA: Considered the student’s asset, a UTMA can significantly reduce financial aid eligibility, with up to 20% of its value factored into calculations.
Pros and Cons of 529 Plans
529 plans are a wise choice for families focused on saving for education. Significant tax benefits and parental control are among their advantages, but you should also be aware of the potential limitations.
Pros:
- Tax-free growth and withdrawals for education.
- The contributor retains control over funds.
- High contribution limits and potential for state tax benefits.
- You may transfer unused funds to another family member.
- Unused funds may be rolled over to a Roth IRA (up to $35,000) under certain conditions.
Cons:
- Your child can only use the money for school.
- Non-qualified withdrawals face taxes and penalties.
- Investment options are often limited to those provided by the plan.
Pros and Cons of Custodial Accounts
UTMAs stand out for their versatility and ability to hold various assets. However, this freedom comes with tradeoffs, such as less favorable tax treatment and eventual control by the child.
Pros:
- Flexibility to use funds for any purpose once the child reaches the age of majority.
- Allows transfer of diverse assets (e.g., cash, stocks, real estate).
- No contribution limits (though subject to gift tax rules).
Cons:
- No tax-advantaged growth; earnings are subject to annual tax.
- The IRS taxes gains and income at the parent’s rate under kiddie tax rules.
- Children may have to file an annual tax return in some cases.
- Your child gets full control of the money after coming of age, and they may not manage the funds as responsibly as you’d like.
Which Should You Choose?
Deciding between a 529 plan and a UTMA depends on your specific financial goals and how you envision your child using the funds. Are you prioritizing education savings, or do you want broader flexibility for their future needs?
- Choose a 529 plan if your primary goal is to save for your child’s education and take advantage of tax benefits. The control it offers and tax-free growth for qualified expenses make it ideal for families focused on education planning.
- Choose a UTMA if you want flexibility and are not certain your child will want or need to use the money for school. UTMAs are an excellent option for transferring diverse assets or preparing your child for financial independence, though they lack the tax advantages of a 529 plan.
Why Work With Raines & Fischer?
Deciding between a 529 plan and a UTMA – or balancing both options – can be a complex decision. Raines & Fischer specializes in helping families maximize their money while minimizing tax obligations. Our expert team stays abreast of the latest tax laws and financial strategies, providing the investment advisory services you need to secure your child’s future.
Contact us today to discuss your financial goals and receive personalized advice tailored to your family’s unique needs.
