Ask a Trainer: Should I Invest in a 529 or a UTMA for My Child?
At The Financial Gym, we are often asked by current and future parents how to best save for their child’s future and education. A common vehicle for this is the 529 account, but you may have also heard of an UTMA. Let’s dive into both.
What you should know about 529s
First things first: there are 51 separate 529 plans—one for each state plus the District of Columbia. 529s are also known as Qualified Tuition Programs (QTP). Each 529 has slightly different features or rules as it relates to their respective states, but their purpose is the same.
There are some important benefits you should know of with 529 plans:
The amount of money you can contribute to the account has a much higher cap than the other education-specific savings option, an Coverdell Education Savings Account (ESA). The cap ranges across states and is a lifetime limit, not an annual limit.
529s are funded with after-tax money just like a Roth IRA. There is a tax exemption for earnings and distributions, meaning the money grows tax-free.
There is no limit to who can invest based on income level, unlike a Roth IRA.
You can repay up to $10,000 in student loans from a 529 account.
529s can be used to cover educational expenses from K-12 education along with trade/vocational schools, colleges, and universities.
Some states accept a tax deduction no matter where a 529 was opened, while most only allow a tax deduction if the 529 is opened in the resident’s state. (Not all states have a tax deduction for 529s and limits vary by state).
In order to benefit from all the advantages offered by a 529 plan, you need to make sure you’re using the money for Qualified Higher Education Expenses (QHEE). This doesn’t mean you cannot use the money for non-educational expenses, but you may pay penalties (usually 10%) and taxes. However, there are ways to still take advantage of the benefits offered by a 529 plan without using it for QHEE. Although, if you’re unsure you’ll use the money for educational expenses, you may consider investing in an UTMA or regular brokerage account instead.
Who can set up a 529 account and how?
Any adult can set up a 529 account and the beneficiary of the account can be anyone including the person who originally opened the account. Doing an online search for your state’s 529 plan will give you results on how and where you can open a 529 account, but remember that you are not limited to using the 529 account offered by your state.
What else should I know about 529 accounts?
Savings Plan v. Prepaid Tuition Plan
Since 529s are state-based, some 529 plans offer two options: one is an education savings plan and another is a prepaid tuition plan. The latter is only provided by a few states but can be another good feature of a 529 plan.
A 529 Education Savings Plan is the most common 529 plan. They are used for saving and investing money for a beneficiary's education expenses.
A 529 Prepaid Tuition Plan allows for the purchase of units or credits at colleges and universities that accept this plan. The key feature is that you’re paying at today’s prices whereas the beneficiary would normally be paying when enrolling and attending the college or university. This type of plan does often come with a residency requirement.
Beneficiaries
You can switch the beneficiary of the 529 account. This is especially useful if you have multiple children within 2 to 4 years in age difference; this way if all of your children choose to pursue higher education you could theoretically use one 529 account to pay for all of their education expenses. However, the closer in age your children are the more of an administrative burden this may become, in which case it may be worthwhile to open multiple 529 accounts.
What you should know about the Uniform Transfer to Minors Act (UTMAs) & Uniform Gift to Minors Act (UGMA)
Simply put, this is a law that allows a minor to receive a gift placed into an account for them. A custodian or even the gift-giver themselves can be appointed to manage the account in lieu of the minor until they’re of age (18 or 21 depending on the state). This law protects the minor from tax ramifications and other legal burdens.
UTMAs and UGMAs are closely related; in fact, UTMAs are an extension of the UGMA. The important distinction is that UTMAs allow for the gifts to be something other than cash and investments. Other assets could include, real estate, artwork, intellectual property, and royalties.
UTMAs are different from 529s because they aren’t specifically designed for education expenses. This means that money in an UTMA is weighted more heavily against students applying for financial aid compared to a 529 account.
Like 529 accounts, UTMAs are state-managed and so each state will have different laws relating to their respective UTMAs.
Up to $16,000 annually can be gifted tax-free. The first $1,100 of investment income and earnings in an UTMA are also tax-free and the next $1,100 is taxed a the child’s rate (typically 10%-12%). Any earnings beyond that are taxed at the custodian’s tax rate to discourage parents from trying to avoid paying higher taxes.
Final Thoughts
When it comes to 529s plans and UTMAs/UGMAs, one option is not always better than the other. As with most personal financial decisions, it’s based on circumstance and context. The biggest consideration is whether the beneficiary/future student will go to college at all, and if so, whether they will need to access financial aid and scholarships.
To discuss how a college savings plan fits into your financial plan, speak to one of our Trainers on Demand.
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