UGMA vs. UTMA vs. 529 Plans: Which One Should You Choose?

Planning for a child’s education requires careful consideration of several factors, including asset ownership, tax implications (including FICA taxes) and financial aid eligibility. Two popular options emerge in this landscape: UTMA/UGMA custodial accounts and 529 plans. While both serve the purpose of accumulating funds for educational purposes, they differ significantly in their key features, making it crucial to understand their nuances before choosing the right fit.

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UGMA/UTMA vs. 529 Plans: Key Differences

The following overview highlights some of the key differences between UTMA/UGMA accounts and 529 plans.

Key Features

UTMA/UGMA accounts are custodial accounts designed for use as vehicles to transfer irrevocable gifts of cash, investments or other property to a minor. A designated custodian manages the assets until the child reaches a certain age (typically between 18 and 21), at which point they receive full control of the funds. UTMA/UGMA accounts offer some tax benefits on investment earnings, with the first portion exempt from federal income tax and the next taxed at the child’s lower rate. However, they lack the tax-advantaged growth potential of 529 plans and come with the significant drawback of relinquishing control over the assets once the child reaches adulthood.

529 plans are specifically designed for education savings. As such, 529 plans offer significant tax advantages. Contributions grow tax-free, and qualified withdrawals for education expenses are not subject to federal or state income taxes (in many cases). Some states even offer additional tax benefits for in-state plan contributions. While offering more flexibility than traditional savings accounts, 529 plans have narrower investment options compared to UTMA/UGMA accounts. Additionally, withdrawals must be used for qualified education expenses, and nonqualified withdrawals face penalties and taxes.

Eligibility Criteria for Establishing and Contributing to Each Plan

Anyone, including parents, guardians, family members and friends of the family, can open a UTMA/UGMA account or start a 529 plan for a child. None of these accounts restrict who can contribute to the account, either. This means friends and family members can give money for birthdays and other celebrations to help fund the college account.

Tax Considerations

For tax purposes, a 529 plan has an advantage over a UTMA/UGMA account. Your tax priorities are an important consideration when choosing between these types of accounts.

• UTMA/UGMA accounts: These accounts offer some tax benefits on investment income. The IRS considers earnings in a UTMA/UGMA account unearned income (along with dividends and capital gains). Although the first $1,300 in earnings in 2024 is exempt from federal income tax, the next $1,300 is potentially taxed at the child’s lower rate. However, exceeding this threshold results in the earnings being taxed at the custodian’s (likely higher) tax rate.

• 529 plans: These plans offer significant tax advantages. Contributions to a 529 plan grow tax-free, and qualified withdrawals for education expenses are not subject to federal or state income taxes (in many cases). Some states even offer additional tax benefits (in some cases, a deduction) for in-state plan contributions. However, nonqualified withdrawals are taxed on earnings and incur a 10% penalty.
  

Asset Control and Custodianship

The approach to asset control and custodianship differs significantly between the two options. This is because the child owns a UTMA/UGMA account but is the beneficiary of a 529 plan.

• UTMA/UGMA accounts: The custodian manages the assets until the child reaches adulthood, at which point full control transfers to them. This can be advantageous for responsible management of the assets during the child’s formative years. However, it also means relinquishing control over how the funds are used once the child gains ownership.

• 529 plans: The account owner retains control over investment choices until the child reaches adulthood. This allows for strategic management of the funds with the specific goal of education savings in mind. The owner also has the option to change the beneficiary at any time — even without the beneficiary’s approval.

Eligible Expenses

A significant difference between UTMA/UGMA accounts and 529 plans is the permitted use of the funds. UTMA/UGMA accounts offer broad flexibility. The funds can be used for any purpose, including education, but also for personal expenses, investments or even starting a business. Since 529 plans prioritize education savings, qualified withdrawals for tuition, fees, room and board, and even K-12 tuition up to a certain amount are not subject to taxes or penalties. However, nonqualified withdrawals face penalties and taxes on the earnings.

Investment Options

The funds in UTMA/UGMA accounts and 529 plans can be invested in a number of products, but UTMA/UGMA accounts provide significant flexibility, allowing investment in a wide range of assets, including stocks, bonds, mutual funds, real estate (UTMA only) and even fine art. 529 plans typically have a narrower range of investment options compared to UTMA/UGMA accounts. The specific options may also vary depending on the chosen plan provider but can include mutual funds and ETFs.

Contribution Limits

Under IRS rules, contributions to UTMA/UGMA and 529 accounts are gifts subject to the gift tax. Currently, any amount greater than the annual gift exclusion ($18,000 for 2024) is subject to federal tax. Beyond that, UTMA/UGMA accounts generally have no contribution limits, allowing you to contribute any amount you wish. Most 529 plans have lifetime contribution limits that vary by state — from $235,000 to $575,000.

Financial Aid Impact

Financial aid eligibility is a crucial consideration when choosing a savings vehicle for your child’s education. Since UTMA/UGMA assets are considered the property of the child, colleges typically include them in their financial aid calculations, potentially reducing the amount of aid a student qualifies for. This is because the financial aid formula assumes a significant portion of these funds can be used toward college expenses, leading to a potentially lower aid package.

529 plans offer a more favorable treatment for financial aid purposes. While the Department of Education still considers them assets, they are typically counted less heavily than UTMA/UGMA accounts. This is because 529 plans are typically owned by the parent or custodian, not the child. Consequently, the financial aid formula assumes a smaller portion of these funds are readily available for college expenses, resulting in a less significant reduction in potential aid.

Flexibility and Portability

Flexibility and portability are key considerations depending on your long-term goals. UTMA/UGMA accounts offer greater flexibility in terms of asset ownership and usage. The funds can be used for any purpose, providing more control but potentially sacrificing tax benefits and potentially impacting financial aid. 529 plans offer less flexibility in terms of usage. However, unused funds may have rollover options to other retirement accounts under certain conditions.

Withdrawal Rules and Penalties

There are no restrictions on withdrawals from UTMA/UGMA accounts. However, withdrawals of investment earnings may be subject to taxes depending on the amount and the recipient’s tax bracket. Withdrawals from 529 plans used for qualified education expenses are not subject to taxes or penalties. However, nonqualified withdrawals are taxed on earnings and incur a 10% federal penalty.

Final Take

Choosing between UTMA/UGMA and 529 plans requires careful consideration of your priorities and long-term goals for your child’s future. UTMA/UGMA accounts offer greater flexibility and broader asset ownership but lack the tax benefits and favorable financial aid treatment associated with 529 plans. 529 plans, while less flexible in terms of usage, offer significant tax advantages, greater control over investment choices and a more positive impact on financial aid eligibility.

Ultimately, the best choice depends on your specific circumstances. If maximizing tax benefits for education savings is your primary goal, even with limitations on usage and investment choices, 529 plans offer a clear advantage. However, if flexibility and the potential to use the funds beyond education are paramount, UTMA/UGMA accounts might be a better fit. Consulting with a financial professional can provide personalized guidance based on your individual situation and long-term objectives, ensuring you make the most informed decision for your child’s future.

This article originally appeared on GOBankingRates.com: UGMA vs. UTMA vs. 529 Plans: Which One Should You Choose?