When thinking about how to finance their child’s college education, many parents turn to an obvious place: a 529 account. A 529 plan offers tax benefits for savings and the opportunity to invest in potentially high-yield assets. But parents have another option, known as UTMA or UGMA accounts, custodial accounts that give minor children the opportunity to save and invest.
But is a 529 plan better than a UTMA or UGMA account? Here are some important things you need to know.
529 accounts vs. UTMA/UGMA accounts
Here are some of the key pros and cons of 529 accounts and the Uniform Transfer to Accounts for Minors (UTMA) and Uniform Giving to Accounts for Minors (UGMA).
Pros and cons of 529 accounts
Plus points
- Tax-deferred growth. Within a 529 plan, money can grow without paying taxes on it.
- Investments with potentially high returns. Money in a 529 can be invested in high-return investments such as stocks and stock funds, which can help the money grow faster.
- Tax-free withdrawals for education. Withdrawals from the account are tax free as long as they are used for qualified educational expenses.
- The beneficiary of a plan may change. If someone else needs to use the plan, the beneficiary can change over time, meaning the plan can work for multiple children or even an adult who wants to go back to school.
- State tax deduction. Some states offer additional discounts on your state income taxes if you put money aside in a 529 plan.
- Student loan repayment. A 529 allows funds to be used to repay student loans, up to $10,000 for the beneficiary and up to $10,000 for a beneficiary’s siblings. But check your country’s laws to make sure refunds qualify as tax-free.
- Reduced impact on financial aid. A 529 plan is not owned by a child, so this type of account, if owned by parents, has a smaller effect on financial aid eligibility, as measured by the Free Application for Federal Student Aid (FAFSA ).
- Roll over to a Roth IRA. The rules surrounding 529 plans changed with the SECURE Act 2.0 of 2023. A plan that has been open for at least 15 years can be converted to a Roth IRA for the beneficiary, up to $35,000 in their lifetime. The feature will not come into effect until 2024.
- More educational opportunities. A 529 plan can also be used to pay tuition for private elementary schools for younger children, as well as for internship programs.
Disadvantages
- Somewhat inflexible. Although the beneficiary can be changed over time and all the money can be transferred to a Roth IRA, you may run into some problems if the money cannot be used. If not, it must be withdrawn and you will owe tax on the income, plus a 10 percent penalty.
- Sanctions for grandparents. A 529 plan owned by grandparents historically hurt a student’s chances of financial aid even more than an account owned by a parent. However, the rules for the 2024-2025 award period are changing and do not require grandparents to report their financial support.
- Limited spending categories. A 529 plan limits qualified expenses to costs that are very closely related to education, and even some expenses that seem like they are related to education are not eligible.
Pros and cons of UTMA/UGMA accounts
Plus points
- Flexibility in investments. A custodial account allows flexible investing in high-return assets, such as shares and equity funds, with a brokerage firm or with more traditional assets, such as CDs with a bank. With a UTMA account you can also invest in real estate and other real estate assets.
- Lower child tax rates. Moving money into a minor child’s account lowers the tax burden on the earnings than if the money were kept with the parent, including a portion of tax-free earnings and a lower initial tax rate.
- Money can be rolled into a 529. A UTMA/UGMA account can still be rolled into a 529 plan later if that makes more financial sense.
Disadvantages
- Greater impact on financial aid. Because they are in the child’s name, UTMA/UGMA accounts have more impact on financial aid eligibility than comparable 529 plans.
- Money belongs to the child by majority. When the child reaches the age of majority, often 18 or 21 depending on your state, the money becomes theirs, meaning it may not be spent as intended.
- Transfers are irrevocable. Once a transfer has taken place, it cannot be undone and belongs to the minor child. Money cannot be transferred to someone else later.
Which one is better?
A 529 account and UTMA/UGMA accounts both offer some clear benefits, but a 529 plan really offers a lot of extras, although at the cost of some flexibility, which isn’t always a bad thing. In addition to the pros and cons above, here’s how experts see their relative benefits.
529s can provide investment convenience
“State 529 education savings plan accounts typically have easy-to-use, pre-configured ‘year of enrollment’ and ‘target risk’ portfolios that make the investment decision much easier for less experienced investors,” says Stephen Jobe, senior vice president at Vestwell, a savings plan provider.
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529s are more flexible than in the past
“The Federal 529 rules continue to evolve and allow more flexibility in the use of funds,” Jobe said.
Some of the inflexibility of the 529 plan has been addressed with recent legislation, allowing 529s to be used for more educational institutions, debt paydowns, and even Roth rollovers. These changes better position the 529 against custodial accounts, even though the latter is still more flexible.
A 529 is better for financial aid calculations
And when it comes to qualifying for more financial aid, a 529 plan is the way to go. That’s because a 529 owned by a parent is treated as an asset of the parent for financial aid purposes, while a UTMA/UGMA account is considered an asset of the child.
“Both have an impact on FAFSA,” says Isaac Bradley, JD, CPA, director of financial planning at Homrich Berg, an asset manager. “But parents’ assets generally have less impact because parents are expected to contribute a smaller percentage of their assets than the child.”
Bradley explains that assets in a parent’s name can amount to an estimated 5.64 percent, while assets in a child’s name are 20 percent.
A UTMA/UGMA may offer too much flexibility
While the 529 is limited to education, that inflexibility can make it better in some cases. This is because a UTMA/UGMA account becomes the property of the minor at the age of majority. So the money can be used as the adult child sees fit, without restrictions, and can be completely wasted.
“If you know money will be needed for higher education, a 529 plan is the most tax efficient and allows the owner to maintain control of the account and make beneficiary changes if desired,” says Bradley.
Other alternatives to a 529 plan
Those looking for other alternatives to a 529 account have a few that could work. A Coverdell education savings account could be a good fit for families who keep their contributions at less than $2,000 per year, although a 529 offers more flexibility, Bradley says.
In short
As a specialized account, the 529 account offers a range of additional benefits that a UTMA or UGMA account can’t really offer, while not suffering from the same disadvantages. Recent changes to 529 plans have made them more flexible than ever and offer even more use cases.
