One of the most common questions I get as a financial planner is “What’s the best way to save for college?” While the choices include 529 plans, UGMA/UTMA accounts (also known as custodial accounts), pre-paid tuition plans and even life insurance, today we will focus on the most common, 529 plans vs. UTMA/UGMA. In my opinion, the 529 plan is a vastly superior savings vehicle and today we will discuss why.
For years, custodial accounts like the UGMA/UTMA (Uniform Gift to Minors Act/Uniform Transfer to Minors Act) were the default savings vehicle for kid’s assets before the 529 plan came along in 1996 as part of the Small Business Jobs Protection Act. The difference between UGMA and UTMA is typically the age at which the child can access the funds themselves. While this can be state specific, it is usually age 18 for UGMA and age 21 for UTMA. Some states even allow for age 25. Herein lies the main reason I don’t like custodial accounts. Do you know a lot of kids who are financially responsible at age 18? Yeah, me neither. College sounds great, but a new car often sounds even better to them. The custodial accounts aren’t without merit, as they allow for unlimited contributions, unrestricted use of the funds, and for UTMAs, a vast array of investment choices. Parents are typically the custodians of the funds and can use them for support of the child, including college, until the child can legally control the account.
The downsides of a custodial account include a complete loss of control by the parents once the child reaches the age of majority. I dislike them for this feature alone. Second, assets held in a custodial account are assessed against a student for financial aid purposes at a rate of 20% from dollar one. Therefore, $10,000 in a custodial account can mean up to $2,000 of lost financial aid each year for college, totaling $8,000 for all 4 years. Finally, earnings inside a custodial account can be subject to the “kiddie tax.” While the kiddie tax has been around since 1986, in which unearned income over a certain amount was taxed at the parents’ rates, now it has become much worse under the new tax cuts. Now unearned income over $2,200 for 2019 is taxed at trust and estate rates, which rise much faster than personal income tax rates. Earnings over only $12,501 are taxed at 37%.
By contrast, 529 plans have contribution limits, which is the same as the annual gift tax limit of $15,000. If both parents contribute, that number is doubled to $30,000 per year. Here’s where I feel the 529 really shines: both parents can make 5 years’ worth of gifts at once as long as they don’t contribute for another 5 years. That’s up to a $150,000 contribution in a single year. Plans will typically limit the total amount of contributions in total to a plan, but those limits are often very high ($400,000 to $500,000-plus in many cases). That doesn’t include earnings, only your contributions. Some states, excluding New Jersey, allow for a tax deduction for contributions to a 529. Assets inside a 529 are counted as a parent’s asset for financial aid purposes instead of a student’s, so the assessment against the student for financial aid purposes is only 5.65% vs. 20% in a custodial account. If the money is used for qualified college expenses, all of the earnings are tax-free. And best of all, you have the option to open as either a Custodial or as an Individual 529. In an Individual 529 you are the account owner and always maintain control of the assets. Each state has at least one plan, and it doesn’t matter which state’s plan you use because they can be used to go to school anywhere in America and even some other countries, such as Canada. I suggest using your own state’s plan if you live in a state that allows for tax deductions, but again, New Jersey doesn’t.
So what’s the down side? If you do not use the funds for college, the earnings (not your contributions) are subject to tax, which you would have paid in a custodial account all along, and a 10% penalty. In my opinion, this is still a great deal. You invested the money you should have paid tax on all along but deferred it for decades and now pay tax and a small penalty on it. Unlike custodial accounts, 529 funds can be transferred between your kids without penalty. Lastly, funds inside a 529 can offer more creditor protection than a custodial account in some states. When you add all of these benefits together, it’s easy to see why I like the 529 better than a custodial account when saving for college.
T. Eric Reich, CIMA, CFP, CLU, ChFC is president and founder of Reich Asset Management and can be reached at 609-486-5073 or firstname.lastname@example.org.
Securities offered through Kestra Investment Services, LLC (Kestra IS), member FINRA/SIPC. Investment advisory services offered through Kestra Advisory Services, LLC (Kestra AS), an affiliate of Kestra IS. Reich Asset Management, LLC is not affiliated with Kestra IS or Kestra AS. The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Investment Services, LLC or Kestra Advisory Services, LLC. This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation.