Which is best for your child?
Saving for your child’s college tuition is more necessary than ever before with tuition rising at an average of 6% a year. Parents should be inspired to invest early in either a 529 Plan or Uniform Gift to Minors Act (UGMA) Account.
What’s the difference? CPA and Financial Planner David Cannon explains, “They are different savings vehicles that you can have for your children. Really, what the differences boil down to are the uses, retractability, eventual transfer rules and tax consequences.”
To understand completely, let’s first look at each individually.
A 529 Plan is the most well-known college savings vehicle, this is because it is meant to be exclusively used for educational expenses. It comes with parameters on how the money is spent, but if used right is virtually tax free.
- OWNERSHIP: Controlled by the account owner (usually the parent). Does not require the funds be relinquished to the beneficiary at a certain age. The funds can even be transferred to another qualifying beneficiary if desired.
- QUALIFIED CONTRIBUTIONS: Only cash is allowed to be contributed to the account.
- INVESTMENT OPTIONS: Limited by the plan, but the selection offers a variety of savings options that cover the bases for average investors.
- EXPENSES: Meant to be used on qualified educational expenses, if not used on a qualified expense the distribution incurs taxes and an additional 10% tax penalty for misuse. Qualified expenses include tuition, fees, books, supplies and equipment required for enrollment or attendance at an eligible higher education institution.
- TAX IMPACT: Growth and distributions are tax-free as long as it’s used on qualified expenses. States may also offer tax incentives for opening one with the state you live in.
- FINANCIAL AID IMPACT: Since it’s considered an asset of the parent (account owner) it reduces aid eligibility by 5.64% of the asset value.
Parents can use this savings vehicle for not only college tuition but can also use $10,000 a year to pay for qualified kindergarten through twelfth grade education. Things like a car to drive to college do not qualify. The earnings portion of a nonqualified distribution is subject to ordinary income taxes and a 10% federal penalty. It should be noted that additional state taxes and penalties may apply.
Although we all wish we could know in advance if our children will receive full-ride scholarships or forgo going to college, the possibility is always on the table.
In these cases, parents have three options. The money can be used by the child and the child can pay the tax and penalties on the withdrawals used on unqualified expenses, it can be transferred to a qualifying relative, or the parents can even take the money back and incur the tax consequences.
“But they have an infinite time horizon to use the money,” David said. “If the kid doesn’t go to college right out of high school, they can hang onto the money and use it if they decide to go later. And, if they get an undergraduate degree paid for, they may want to pursue a post-graduate degree and can use the monies for that.”
UGMA’s offer more flexibility for the child later in life because it is not limited to educational expenses, but are considerably different than 529 Plans in a few key ways.
- OWNERSHIP: The custodian of the account (usually the parent) owns the account until the child is the age of majority, which varies by state, then the child has complete ownership.
- QUALIFIED CONTRIBUTIONS: Can be funded with any combination of cash and investments.
- INVESTMENT OPTIONS: There are less restrictions on investing options.
- EXPENSES: Can use on any expense for the child, not restricted to educational expenses.
- TAX IMPACT: Contributions and gains are subject to kiddie tax.
- FINANCIAL AID IMPACT: UGMA’s are considered an asset of the student and reduce aid eligibility by 20% of the asset value.
One of the important differences to note is UGMA accounts do not have the same transferring options as 529 Plans. This type of account cannot be transferred to a beneficiary or taken back in a situation where parents may want to do so.
“A UGMA is a permanent, irrevocable gift,” said David. “All amounts contributed to it cannot be taken back. It will be transferred to the minor at the age of majority, at which time the minor has complete ownership of the account and can do anything with the monies.”
UGMA’s can be used as an alternative or in addition to a 529 Plan. Whether or not parents should open both for their child depends on their long-term goals.
“It depends on your goals and your financial resources,” David said. “If you want to help them with college, the 529 Plan is the best option. But if you also want to help them with other items in young adulthood like getting a house or a car, then yes, having both is a good idea.”
The tax impact may be the most important factor to consider before opening this type of account.
COMPARING THE TAX IMPACT
The tax-free benefits of a 529 Plan make for an amazing option for most families saving for college tuition. 529 Plan contributions can grow without taxation, and more dollars in the account turn into more dollars returned over time.
On top of those tax benefits, children aren’t taxed on withdrawals if it’s used for qualified expenses. But if for some reason funds need to be used for something that’s not qualified, the distribution is subject to standard income taxes and an additional 10% tax penalty.
UGMA’s don’t have a penalty or requirements for use, but gains are taxed on an annual basis based on kiddie tax rules.
“Kiddie tax rules can be complicated to understand,” said David.
If the child’s unearned income, (such as earnings from interest or dividends on the account) is below $2,200 in a year, you’ll pay the child’s tax rate for trusts and estates, which is very low or potentially even nothing in some instances.
If the unearned income on a UGMA account exceeds $2,200 a year, it gets taxed based on the parents’ highest marginal federal income tax rate. If the unearned income is greater than $11,000, a separate tax return must be filed for the child, if it is lower then it can be included on the parents’ tax filings.
“Ultimately it boils down to how you want the money to be used, and how sure you are in that choice,” said David. “While UGMA’s offer the greatest flexibility in use, the 529 Plans offer the greatest tax benefits for college savings.”
The bottom line is, the earlier you begin saving for your child’s college, the better. Both UGMA and 529 Plan options can help you achieve this goal.
The savings vehicles you use to accomplish your long-term goals matter. Our team can help you feel confident in your savings plan.