When saving for your child or grandchild’s college education, there are several types of education savings accounts to choose from. Three of the most popular college savings accounts are Uniform Gift to Minors Act (UGMA)/ Uniform Transfer to Minors Act (UTMA) accounts, 529 College Savings Plans, and Coverdell Education Savings accounts. Each type has specific rules, laws and taxes associated with it, so it’s important to know the differences before choosing where to invest your money. Walsh & Associates and LPL Financial do not provide legal or tax advice or services so we suggest you consult your legal or tax professional regarding your specific situation. In this article, we cover the pros and cons of each type of account.

UGMA and UTMA Accounts

UGMA and UTMA accounts are education savings accounts that allow adults to make financial gifts to a minor while acting as custodians of the account. Once money is put into these accounts, it is legal property of the minor, but it is the adult custodians’ duty to make sure the money is invested sensibly so that it will benefit the minor in the future. Depending on the state, once the minor reaches 18 or 21, they gain full control of the account and can spend the assets on what they deem necessary for their education. That means parents, or whoever is a custodian on the account, cannot make any stipulations on the expenditures.

As far as taxes are concerned, there is no IRS penalty for withdrawing money, however, any profits made in an UGMA or UTMA are generally taxed at the child’s – usually lower – tax rate, rather than the parent’s rate. This means the student could be subject to the “kiddie tax”, which applies to college students between the ages of 19 and 24. For 2016, under the kiddie tax rule, the first $1,050 of unearned income a student earns will not be taxed, and the second $1,050 of unearned income will be taxed at the student’s tax rate. Anything in excess of $2,100 though will be taxed at the parent’s tax rate. The only way to avoid this is if the student under the age of 24 is providing over half of their own support from their own earned income (aka from a salary, not stocks). This would allow the student’s unearned income to be taxed at their own tax rate, not their parents’ higher rate. For complete details, visit IRS publication on the “Kiddie Tax”.

Another factor to consider with an UGMA or UTMA is that they will affect the minor’s ability to receive financial aid. This is because the Free Application for Federal Student Aid (FAFSA), looks at both the parents’ and student’s income when determining eligibility for aid. Since the assets in an UGMA/UTMA are considered the child’s money, it can weigh harshly on their chance at financial aid.

529 College Savings Plan

Section 529 plans have become one of the more popular types of college savings accounts in recent years. They work similar to IRAs in that the earnings are not subject to federal tax or, generally, state tax, as long as you spend the profits on federally approved college costs (i.e. “qualified expenses”). Contributions to a 529 plan, however, are not deductible. Unlike UTMAs/UGMAs, the parent or grandparent who is contributing to the 529 plan is the permanent account holder and is in charge of the money for all time. This is good news for a parent who may be worried about how their child chooses to spend their money, or for parents who may need to withdraw cash from the 529 account.

Beware of restrictions though - money that is withdrawn from a 529 plan that is not used for higher education expenses is subject to a 10% penalty and income tax on the profits. Section 529 plans also have fewer investment choices than UGMA/UTMA accounts, which may not be favorable for some investors.

Prior to investing in a 529 Plan investors should consider whether the investor's or designated beneficiary's home state offers any state tax or other benefits that are only available for investments in such state's qualified tuition program. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary. Please consult with your tax advisor before investing.

Coverdell Education Savings Accounts

Coverdell Education Savings Accounts (ESAs) have benefits that fall someplace in between UGMA/UTMA accounts and 529 plans. Like an UGMA or UTMA account, the Coverdell ESA is a gift to the student once they are of age. But unlike an UGMA or UTMA, the account must be used for qualifying education costs – like a 529 plan, but with less restrictions on what counts as an education expense. Unlike a 529, the assets from ESA accounts can be used for K-12 school expenses, including private school tuition, uniforms, books, etc. Should the student not use the money for qualified education expenses by the time they’re 30, the money can be rolled over into another child’s Coverdell ESA account. After-tax dollars are used to fund the account, but the account grows tax-free and withdrawals for education expenses are not taxed.

Coverdell Education Savings Accounts have a few very limiting restrictions that may turn off investors. To qualify for one of these accounts, your modified adjusted gross income must be less than $110,000 (or $220,000 for joint returns). If withdrawals are made for something other than a qualified education expense, the beneficiary (student) will be charged a 10% penalty on the gains. Also, the contribution limit is very low – at just $2,000 per year, it can be hard to save enough to cover all college costs.

Interested in opening your own College Savings Account? Depending on your individual situation, any one of these options could be a great saving tool. As fully comprehensive financial planners here at Walsh & Associates, education planning is one of the core areas we cover for our clients. If you have questions about any of these plans, do not hesitate to contact us.

1. Topic 553 - Tax on a Child's Investment and Other Unearned Income (Kiddie Tax), IRS (2016) https://www.irs.gov/taxtopics/tc553.html

2. An Introduction to 529 Plans, SEC (2014) https://www.sec.gov/investor/pubs/intro529.htm

3. Coverdell Education Savings Account (ESA), IRS (2016) https://www.irs.gov/publications/p970/ch07.html