Saving for college is one of the most significant financial goals for families. With the cost of higher education steadily rising, many parents and guardians are seeking effective ways to build a college fund. Several savings tools cater specifically to educational savings and long-term investments for minors. Among the most popular are 529 Plans, Trust Accounts, and UTMA/UGMA Accounts. Each has its advantages, tax implications, and limitations, making it crucial to choose the right option based on your goals. This blog will compare these three college savings tools to help you make an informed decision.

529 Plans: Flexible and Tax-Advantaged Education Savings

A 529 Plan is a tax-advantaged savings plan designed specifically for future education costs. These plans are popular because they offer tax-free growth and tax-free withdrawals when used for qualified education expenses.

Key Features of 529 Plans:

  • Tax Benefits: One of the biggest advantages of a 529 plan is its tax benefits. Earnings grow tax-deferred, and withdrawals used for qualified education expenses are free from federal income tax and, in many cases, state taxes. These expenses can include tuition, fees, books, and even room and board.
  • State-Sponsored: 529 plans are state-sponsored, meaning that every state offers at least one version of this plan, although you can invest in plans from other states as well. Some states provide additional tax benefits to their residents, such as a state tax deduction for contributions.
  • Flexibility in Use: Initially designed for college expenses, 529 plans now allow for a broader range of educational costs. For example, they can be used for K-12 tuition expenses (up to a certain limit), apprenticeship programs, and even up to $10,000 of student loan repayment.
  • Ownership Control: The account owner (typically a parent or grandparent) maintains control over the funds. This means that even after the child reaches the age of majority, the owner decides how the funds are spent.
  • Transferability: If the beneficiary decides not to go to college, you can easily transfer the 529 plan to another family member without penalties, such as a sibling or cousin.
  • Contribution Limits: While there is no annual contribution limit, contributions above the federal gift tax exclusion amount ($17,000 per individual in 2023) may be subject to gift taxes. However, a special rule allows for lump-sum contributions of up to five years’ worth of exclusions at once ($85,000 in 2023), which is especially useful for estate planning purposes.

Drawbacks:

  • Restricted Use: Funds must be used for qualified education expenses, or you’ll face a 10% penalty on earnings plus income taxes on non-qualified withdrawals.
  • Investment Choices: While 529 plans offer investment options, these are typically limited to the choices provided by the plan, and some may have higher fees or limited flexibility compared to other investment accounts.

Trust Accounts: Customized, Private Savings with More Control

Trust Accounts are legal arrangements where a trustee manages assets on behalf of a beneficiary. In terms of college savings, trust accounts can provide a flexible way to save for a child’s future, including educational expenses.

Key Features of Trust Accounts:

  • Tailored to Specific Needs: A trust can be highly customized, allowing parents or grandparents to specify exactly how and when the assets are to be used. For example, a trust might restrict disbursements to cover only education costs or release funds at certain ages.
  • Control Over Assets: With a trust, the trustee retains control over the funds even after the beneficiary reaches adulthood. This can prevent a young adult from mismanaging or wasting the money.
  • Tax Considerations: Trusts are subject to more complex tax rules than 529 plans or UTMA/UGMA accounts. Depending on how it is structured, the trust may be taxed at the trust’s tax rate (which is typically higher) or at the beneficiary’s rate. However, with proper planning, a trust can offer tax advantages, particularly for large estates.
  • Broad Usage: Unlike 529 plans, trust accounts are not limited to education expenses. The trustee can use the funds for any purpose that aligns with the terms of the trust, including housing, living expenses, or other needs.
  • Wealth Transfer and Estate Planning: Trust accounts can play a dual role in saving for education while also facilitating the transfer of wealth from one generation to the next, minimizing estate taxes with proper structuring.

Drawbacks:

  • Complexity and Cost: Establishing a trust requires legal expertise and can be more expensive to set up and maintain than other savings vehicles. Trustees may also charge fees for managing the trust.
  • Tax Efficiency: Trusts do not offer the same tax benefits as 529 plans. While income earned by the trust is taxable, using a trust with the right structure can mitigate some of these tax burdens.
  • No Special Education Tax Breaks: Unlike 529 plans, trust funds don’t have special tax advantages specifically for educational expenses.

UTMA/UGMA Accounts: Custodial Accounts for Minors

UTMA (Uniform Transfers to Minors Act) and UGMA (Uniform Gifts to Minors Act) accounts are custodial accounts that allow adults to transfer assets to a minor without setting up a formal trust. These accounts are often used to save for future expenses, including education.

Key Features of UTMA/UGMA Accounts:

  • Custodial Control: A custodian (usually a parent) manages the account until the minor reaches the age of majority (18 or 21, depending on the state). At that point, the child gains full control of the funds.
  • Flexible Use of Funds: Unlike 529 plans, there are no restrictions on how the funds in a UTMA/UGMA account are used. Once the minor reaches adulthood, they can spend the money on anything, whether it’s for college, starting a business, or even non-educational purchases.
  • Investment Options: UTMA/UGMA accounts allow for a broader range of investment options compared to 529 plans. You can invest in individual stocks, bonds, mutual funds, and other financial instruments, offering more control over how the funds grow.
  • Tax Benefits: Earnings in UTMA/UGMA accounts are subject to a child’s tax rate, which is generally lower than that of an adult. However, the “kiddie tax” may apply once unearned income exceeds a certain threshold ($2,500 in 2023), meaning that the excess earnings could be taxed at the parent’s rate.
  • No Contribution Limits: There are no restrictions on how much you can contribute to a UTMA/UGMA account, but contributions above the federal gift tax exclusion may be subject to gift taxes.

Drawbacks:

  • Ownership Transfer: Once the beneficiary reaches the age of majority, they gain full control of the account. This means they could potentially spend the funds in ways the donor may not have intended, such as on non-educational expenses.
  • Tax Disadvantages Compared to 529: UTMA/UGMA accounts don’t offer the same tax-deferral or tax-free withdrawal benefits for educational expenses as 529 plans do.
  • Impact on Financial Aid: Assets in a UTMA/UGMA account are considered the child’s property, which can significantly reduce their eligibility for financial aid under the FAFSA (Free Application for Federal Student Aid).

Which College Savings Tool is Right for You?

When deciding between 529 plans, trust accounts, and UTMA/UGMA accounts, it’s important to consider your family’s financial goals, the flexibility you desire, and the tax implications of each option.

  • 529 Plans are ideal for families who are sure they want to save for education and want to take advantage of tax-free growth and withdrawals for qualified education expenses.
  • Trust Accounts offer more control and flexibility over how and when funds are distributed but come with more complexity and potential tax burdens.
  • UTMA/UGMA Accounts provide flexibility in how funds are used, but the child gains full control at adulthood, and the tax benefits are less favorable for education-specific savings.

By carefully considering your priorities and financial situation, you can choose the tool that best fits your needs and ensures your child has the resources for a bright educational future.

Eric Moss
Director

Disclosures:

This is provided for informational purposes only and should not be interpreted in any way as investment, tax, accounting, legal or regulatory advice. An investor must take into consideration his/her individual circumstances. 

There is no guarantee investment strategies will be successful. Investing involves risks including possible loss of principal. There is always the risk that an investor may lose money. A long-term investment approach cannot guarantee a profit.  All expressions of opinion are subject to change. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services. Investors should talk to their wealth advisor prior to making any investment decision.