Of course, not everybody is able to pay for their children’s college expenses using loans. But, just like with other financial plans, you (and your child) will be far better off if you save early and often.
With college costs on the rise, it’s not enough to stash your money in a savings account and pray you have enough for college. You’ve got to find a way to earn some decent interest. And, when we talk about earning a return, investing in the markets is usually the best place to look.
There are several ways to get the most out of your college savings dollars. Two of the most popular are 529 college savings plans and UGMA (Uniformed Gift to Minors Act) accounts. Let’s examine what these accounts offer and compare their benefits and disadvantages.
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What is a 529 College Savings Plan?
529 college savings plans are specifically designed to save and invest money for future educational expenditures. Often referred to as a 529 plan, states and some third parties actually operate these tax-advantaged plans. There are actually two types of 529 plans, but this article will focus specifically on the “college savings plans.” (Families also have the option of using “prepaid tuition” plans.)
Every state and the District of Columbia offers at least one 529 plan. Money contributed to these accounts grows federal income tax free. Withdrawals are also tax-free when used for qualified expenses, which can now include private K-12 education expenses.
Since 529 plans are operated by the states, the rules vary. Furthermore, some states offer more income tax benefits to plan participants than others. For instance, my home state of Indiana offers a tax deduction of up to $1,000 per student per year for 529 contributions. Other states offer more or less in tax benefits. You can find out more about those benefits here.
Furthermore, while most states also offer state income tax free growth on 529 balances, not all do–especially if you hold an account administered by another state. And with the new K-12 eligibility rules, it’s unclear how some states will deal with the expansion in federally eligible expenses.
All that to say: be sure you understand your state’s particular benefits and rules. You can choose to use an out-of-state account if you’d prefer, or if that’s a better fit for you. But understand how that works with both the 529 plan you choose and your state’s tax laws.
Benefits of 529 Plans
The tax benefits of 529 plans can be excellent, but that isn’t all there is to like. Here are a few more reasons to love 529 plans:
- Tax-free growth on contributions.
- Tax-free withdrawals on qualified educational expenses.
- Most states offer state income tax deductions or credits.
- Beneficiaries my be changed to another person easily.
- No federal tax reporting requirements.
- No income or age restrictions.
- Account stays under control of the participant (typically a parent) not the named beneficiary (typically a child).
Of course, there are a few drawbacks to using a 529 plan as well.
- Money must be used for qualified educational expenses or is subject to federal income tax and a 10% penalty upon withdrawal.
- Investment options are limited.
- No guarantee of return.
- Subject to account management fees.
What is a UGMA Account?
A UGMA account is a special account which essentially allows minors to own financial securities through the use of a trust. Funds placed into the account are irrevocably gifted to the minor. A custodian operates the account until the minor comes of age, which is typically 18 or 21 and determined by the state in which the account is created. At that time, they have full control over the account and can spend the money in whatever way they see fit.
Accounts are created under the minor’s Social Security Number, and gains on the money are taxable to the child at the “Kiddie Tax Rate.” Parents are responsible for filing and reporting the income on their child’s income tax return. However, you don’t have to use funds in a UGMA for educational purposes.Thus, if your child decides not to attend college, they can use the money for other pursuits.
Benefits of a UGMA
Using a UGMA account as a vehicle for funding a child’s educational expenses does have some advantages, including:
- Funds do not have to be used on educational expenses.
- No income restrictions or contribution limits.
- Variety of investment options available.
- Funds can be used for any purposes.
As with 529 plans, UGMA accounts have some disadvantages as well:
- Growth on the funds is taxed at the child’s income tax rate.
- The child can make decisions–even bad ones–with the funds when they’re of age.
- You may not change beneficiaries.
- Counted as an asset of the child when applying for student aid, making it harder to receive funding.
Comparing 529 Plans vs. UGMA
Now that you’ve seen what each of these plans have to offer, take a look at the chart below for a side-by-side comparison of these plans.
|Federal tax advantages?||Yes. Gains are not taxed; withdrawals not taxed, provided they are used for qualified educational expenses.||No. Minor is responsible for taxes on earnings and gains.|
|State tax advantages?||Yes. Most states offer income tax credits or deductions.||No.|
|Restrictions on use?||Yes. Funds must be used for qualified educational expenses or be subject to federal income taxes plus 10% penalty.||No. Must be used for minor's benefit prior to coming of age.|
|Who controls funds?||Plan participant, not beneficiary.||Custodian controls funds prior to minor coming of age; child gains full control of funds once they are an adult.|
|Can change beneficiaries?||Yes.||No.|
|Variety of investment options?||Limited.||Yes.|
Should You Use a 529 Plan or a UGMA for College Savings?
In the past UGMA accounts were particularly popular because parents were able to move some of their investment income into these accounts and save money on their taxes. However, with the expanded Kiddie Tax rules now in play, that option looks far less attractive.
Personally, I love the tax savings available with the 529 plan. In addition to the funds growing tax free, my kids will be able to use the money on qualified educational costs without incurring any tax penalty. Additionally, my home state provides a generous tax credit for using the 529 plan.
So, what’s the best college savings option for you? As always, the choice depends on your personal situation and individual goals. If you want to ensure the money you save can only be used for educational expenses, a 529 plan may be the way to go. However, if you are concerned about your child not attending college or you want a wider variety of investment options, a UGMA account could be your best bet. No matter how you decide to save, having something is always better than having nothing.