If you’re a parent looking to save money for your child’s future, you may be thinking about saving with a 529 plan or an UTMA/UGMA custodial account. These two investment options both help you save money on the behalf of your child (the account’s beneficiary), but it’s important to pick the right account for your needs. In this post, we provide an overview of each and the key differences between the two.

What is a 529 plan?

A 529 Savings Plan is a popular education savings investment account that is widely recommended by financial advisors because it offers significant tax advantages. Funds saved in 529 plans can be used to pay for college costs (tuition, fees, books, computers, housing, etc.), K-12 private school tuition, apprenticeship programs, student loan paydown, and other learning expenses. Because the account is owned by the parent instead of the child, it has much more limited impact on the child’s eligibility for financial aid in the future.

What are UGMA/UTMA custodial accounts?

UGMA/UTMA custodial accounts can be opened by a parent on behalf of a child. The main distinction between an UTMA (Uniform Transfer to Minors Act) account and an UGMA (Uniform Gifts to Minors Act) account is that UTMAs need to be transferred to the child before age 25 (or earlier in some states), while UGMAs need to be handed over to the child at age 18. Once the account is transferred to the child, the parent loses all control over the account and how the funds are spent. Because the account is owned by the child, it will have a more severe negative impact on the child’s eligibility for financial aid.

Tax benefits

All of your savings in a 529 plan will grow completely tax-free from federal capital-gains tax (and possibly even state capital-gains tax depending on your state). For UGMA/UTMA accounts, the first $1,050 in investment earnings is tax-free, and the next $1,050 is taxed at 10%. But if you save any more than that (i.e., save more than $2,100), earnings will be taxed at the highest marginal tax rate based on the parent’s income. So if you’re planning to save more than $2,100 for your child’s college education, you’ll end up saving much more in taxes by choosing a 529.

Verdict: 529s offer superior tax benefits

Financial aid

When your child goes to college and applies for financial aid, a 529 plan will be classified as the parent’s asset and only 5.64% of its value will be used to calculate the family’s expected contribution to the cost of college. UGMA/UTMAs, on the other hand, will be classified as the child’s asset, which means 20% of the account’s value will be expected to be used to pay for college each year. It can be more difficult for your child to qualify for financial aid when more of the savings are classified as the child’s assets.

Verdict: It’s easier to qualify for financial aid with a 529 plan

Transferring to another child

If your child no longer needs the funds, you easily can transfer your 529 savings to another family member (such as another child, cousin, niece/nephew, or grandchild), and there are no tax penalties. With UGMA/UTMAS, maintaining control of the funds is significantly more difficult as funds are considered an asset owned by the child and are permanently transferred at a specific age (18-25, depending on the state).

Verdict: 529s enable much greater control for the parents

Use of funds

529s grow tax-free and money in those accounts can be used to pay for qualified education expenses, but if you take the funds out for non-qualified expenses, the earnings of your investment will be subject to income tax and a 10% penalty (i.e., you would pay tax and penalty on the amount that your account grew, not the amount you put in). With UGMA/UTMAs, your child can use those funds for any purpose that he or she chooses. Once your child hits the “age of maturity” (typically 18 or 21), the entire balance of the account is transferred to them and they can do whatever they want with those funds. If the intended purpose for the savings is for education-related costs, then a 529’s more limited flexibility can be a positive.

Verdict: 529s are better for education, but UGMA/UTMAs are a good option if you’re not sure you want to save for education costs

Our mission is to help families save in the best way possible for education, which is why Backer recommends investing with a 529 plan. We can get you started with one in less than 5 minutes! We’ll help make sure you select a gold-rated plan, choose the right portfolio option for your family, and save even more with help from family and friends.

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