Consider These Alternatives to 529 Plans to Save for College

There are several options other than 529 accounts when it comes to saving for your child’s college education.  Among them are custodial accounts under the Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA), as well as Coverdell Education Savings Accounts (ESAs).

The 529 has clear advantages over UGMA/UTMAs and Coverdells, including the ability to invest large sums, grow tax free, take advantage of state-tax deductibility where applicable, and make tax-free withdrawals if the money is used for qualifying higher-education expenses.

Still, some families may crave the flexibility UGMA/UTMAs and Coverdells provide. There are other reasons to use these accounts as well, depending on the circumstances.  Here’s what you need to know before deciding which kind of account is best for your family.

The advantages of UTMAs

UGMA and UTMA accounts are very similar, but UTMAs allow a wider range of assets such as real estate, fine art, patents and royalties. These accounts are not only for college savings, but many families use them for this purpose.

UGMAs/UTMAs allow you to make unlimited contributions to the account (though gifts over $15,000—or over $30,000 for couples—could be subject to the gift tax). In exchange, earnings under $2,200 are either untaxed or taxed at the child’s much lower rate. (Note that these amounts are for 2021 and are indexed for inflation.)

Once the money is deposited, it belongs to your minor child and must be used for your child’s benefit. Your job as custodian is to keep the money safe.

Depending on the state, your child will take control of the account at age 18, 21 or 25. The money can be used for any purpose, unlike a 529, which can generally only be used for higher education expenses. If the 529 is not used for one child, it can be transferred to another child or relative, or even yourself, as long as the money is used for qualified education expense purposes.

Another plus: While the investment options in 529s are usually limited to choices offered by your plan, UTMAs give you free rein to invest in anything you want, including individual stocks, mutual funds and real estate.

Yes, there are downsides

UGMAs/UTMAs have drawbacks, which is why many parents, including Michele Claybrook-Lucas of Philadelphia, have switched to 529s once they became available.

When Claybrook-Lucas’s daughter Ciara was born, in 1995, Claybrook-Lucas opened a UTMA to get started on college savings right away. Working for a large financial services firm at the time, she was sold on the benefits of early savings and compounding.

“I started saving consistently, putting aside $250 or $300 a month,” says Claybrook-Lucas, who is now the director of training and workforce development at the Community College of Philadelphia. “We had it for four or five years, but then the 529 came out and I liked the tax advantages, so I stopped saving in the UTMA.”

The UGMA/UTMA features a tax bite the 529 does not: Dividends, capital gains and income above $2,200 (indexed for inflation) are subject to the “kiddie tax.” After that threshold, earnings are taxed at the higher rates applied to trusts and estates. 529s, on the other hand, feature tax-free growth. If you invest in your home state’s plan, there might also be a state tax deduction for your investment.

By the time Ciara went off to Ithaca College to major in journalism, the bulk of her college savings was in the 529. After she graduated in May of 2017 and landed a job as a reporter at a TV station in Savannah, Georgia, there was still money in the UTMA. That proved handy because of the flexibility of the UTMA.

“She had to relocate, and that’s where the UTMA came in,” explains Claybrook-Lucas. “We furnished her apartment, paid the security deposit, paid for her car, all from the money in the UTMA. We couldn’t have used the 529 money for that.”

Keep in mind that, because custodial accounts are considered the child’s asset, a UTMA could hurt you when applying for financial aid, as student assets carry more weight on the Free Application for Federal Student Aid (FAFSA).

Another negative: Once you make a gift into an UGMA/UTMA, it’s no longer your money. While your children are minors, you may use it for their benefit. But at the age of majority, it is theirs, and they can do what they want with the money. Think carefully about whether you’re comfortable giving up that kind of control to a young person who may or may not be financially responsible.  

A different kind of flexibility with Coverdells

Coverdell Education Savings Accounts come with tax-free earnings and withdrawals if the money is used for qualifying educational expenses. The money in a Coverdell isn’t limited to higher education, as the funds in a 529 are; it can be used for K-12 expenses, too without limit. For 529 plans, the use for elementary and secondary education is limited to $10,000 per child per year. Those expenses might include tuition, tutoring or school uniforms. Any unused portions can be rolled over to another person.

Like a 529, the portion of the funds that represent the gains are taxable if they are withdrawn and used for non-education expenses. There will also be a 10% penalty.

On the downside, Coverdells only allow you to invest $2,000 a year. 529s allow you to invest much more.  Limits are set by the state but can be as high as $250,000.   A provision of the federal tax law also allows you to accelerate 5 years’ annual gift tax exclusions so that you could contribute $75,000 (or $150,000 for couples) without incurring gift tax.  If you (or your spouse should die during that five-year period, a pro rata portion is brought back into your taxable estate. You should consult your tax and legal advisors for advice concerning your particular circumstances.

Footnotes

Ilana Polyak is a freelance writer who specializes in personal finance and the financial advisory industry. Her work has appeared in The New York Times, Barron's, Kiplinger's Personal Finance, Bloomberg BusinessWeek and CNBC.com, where she is a frequent contributor.

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