What Financial Accounts are Useful to Save for a Child?
As a CERTIFIED FINANCIAL PLANNER™ and financial coach, I'm aware that saving for the benefit of a loved one, like a child, can be a great (and intrinsically rewarding) thing. You're giving your loved one a head start, and if you're doing it right, you're teaching them about saving and giving them some good financial habits along the way. If you're a parent, you should have open and honest communication with your child about the money you're putting aside for them and the expectations you have for it. If you're a grandparent or relative, you should have an open and transparent dialog with your loved one's parents or your loved one directly if they're of age about the same thing. Putting aside money for a loved one, while a generous gift, affects them, and you should allow them to be involved and work it into their financial plan instead of discretely saving money for them as a surprise gift.
What many don't know is that there are multiple options when it comes to saving for children. While there's nothing wrong with a savings account, these options allow for optimally planning your loved one's finances in a smart and structured way. I highly recommend seeking the guidance of a financial professional like myself when deciding between options!
What is a UTMA or UGMA Account?
UTMA (Uniform Transfer to Minors Act) and UGMA (Uniform Gifts to Minors Act) are called custodial accounts. Generally speaking, these are accounts that relatives (parents or otherwise) can set up to help save money for a child's future educational expenses. While college is the intended purpose of UTMA/UGMA, there isn't a penalty for non-educational use. Custodial accounts can be used to purchase investments, like mutual funds, stocks, and bonds. It's important that investments made in these account match the client's risk tolerance and objectives.
What is a 529 plan?
A 529 plan is an increasingly popular way of creating a college fund for a child. There are more tax advantages with a 529 plan than a custodial account, and they're less flexible when it comes to using them for non-educational purposes. 529's are only able to be funded with cash investment. Unlike custodial accounts, 529 plans have contribution limits that are set by the plan. There are potential drawbacks for FAFSA eligibility as well as tax stipulations attached (I'll cover these below).
What are tax differences in a custodial account versus a 529 plan?
There are a few tax differences in the treatment of UTMA/UGMA accounts and 529 plans. You can contribute up to $15,000 per year to both 529 plans and UTMA/UGMA accounts tax-free as a part of your gift tax exclusion. UTMA/UGMA accounts are subject to income tax on earnings and capital gains, whereas 529s grow tax free on earnings and capital gains. The beneficiary of the 529 plan can also use up to $10,000 on tuition, board, and other approved educational expenses tax-free per year with a 529 plan. A CERTIFIED FINANCIAL PLANNER™ or financial coach can help guide you through understanding how and when taxes will affect each type of account.
Who has control over a custodial account or a 529 plan?
With a 529 plan, the owner/opener of the account is in control of the money at all times. With a UTMA/UGMA account, the control of the money and account are given to the beneficiary when they come of age (18 or 21, depending on your state). As a planner I advise parents to think about their child's spending habits, before opening a custodial account that their child will have unfettered access to in the future. Many parents/relatives want to make sure that the money they have been saving is being used for its intended educational purposes. This is yet another reason that 529 plans are growing in popularity.
Is it possible to transfer or change beneficiaries in a 529 or custodial account?
Transferability is another area that 529 plans are more flexible than custodial accounts. With a 529 plan, if your loved one either decides not to go to college or doesn't need the money you've saved for whatever reason, you're able to change the beneficiary of the account. Unfortunately, with UTMA or UGMA accounts, this isn't possible. If you have multiple children or multiple children in your family, this makes 529 a great option. There's realistically no way of knowing what your child, grandchild, or relative may decide to do as they mature and come of age, so the flexibility of a 529 is fantastic.
Why would you use one account over the other?
UTMA or UGMA accounts are more traditional than 529 plans, but that doesn't necessarily make them better. One may decide to stick with a custodial account because of the different options for funding the account, or to earmark the account for something besides education. For most, however, the tax advantages and flexibility of a 529 account will outweigh the limited funding options (cash only). Many are going in the direction of the 529 plan for FAFSA/financial aid purposes. If you're the child's parent with a 529 plan, having below ten thousand dollars in your account will not affect your child's expected family contribution requirements for FAFSA. If the 529 is above ten thousand dollars (and the account is in the parent's name), only 5.64% will be counted towards the expected family contribution. As an FYI: 20% of student owned assets count towards the expected family contribution.
Disadvantages of 529 plans and custodial accounts
While taxes and flexibility both favor the 529 plan, the lack of funding options is a disadvantage. Depending on your goal, it could also be a disadvantage that 529 plans have a 10% tax penalty on non-educational use. UTMA/UGMA, however, have more tax exposure and aren't able to be moved between children or beneficiaries. Custodial Accounts also give complete control to the beneficiary when they become of age of majority in their state (18 or 21).
A CERTIFIED FINANCIAL PLANNER™ can help you create a plan to save for your children
While both UTMA/UGMA custodial accounts and 529 plans have their advantages and disadvantages, either can be a fantastic option. When saving and planning for your child or loved one's financial future, as long as it's thought through to fit into your (and your relative's) financial plan. If your not the child's parent, transparent and open communication with the adult (and possibly child) is the key to success. Remember that even though you're the one saving, what you're saving will also affect their financial plan as well as their taxes and financial aid eligibility.
Are you interested in saving for a child or creating a college fund? If you need guidance in deciding what options are best for you and your child, please call or email to schedule an appointment with me. I'll work with you to create a financial plan that's optimized for you.
Until next time...this is Melissa Making Cents!
Melissa Anne Cox CERTIFIED FINANCIAL PLANNER™ is also a College Planning and Student Loan Advisor and Financial Coach in Dallas, Texas.