Which Accounts Are Best To Help My Grandchildren Pay For College? 🎓

So, you would like to set aside some money for your grandchildren. You want to build an early inheritance or, more likely, you’d like to get a jump on their college fund. In either case, you’ll want to know more about Uniform Gifts to Minors Act (UGMA), Uniform Transfers to Minors Act (UTMA) accounts and 529 plans. All three of these accounts enable you to give money to the next generation, but each account comes with some important nuances that make it important to understand the rules and how they best apply to accomplish the goal of getting money to the grandkids. Here is what you need to know about UGMA accounts vs. UTMA accounts vs. 529 plans and how to choose between them:

The Basics of UGMA and UTMA Accounts 

UGMA and UTMA accounts are custodial accounts that you can set up for minor recipients. They effectively serve as a trust that holds the assets during your grandchild’s childhood. You can deposit almost any form of financial product in these accounts, such as cash, stocks or bonds. The account, both its principle and any investment return, becomes the property of the recipient when he or she reaches the age of majority, which is typically from 18 to 21. 

This is an irrevocable transfer. Once you deposit funds into a custodial account under either of these laws, you cannot access or withdraw the money. It becomes the property of the minor recipient. The recipient also cannot access the money until they come of age. You cannot specify a purpose for the UGMA or UTMA account after the recipient comes of age. The money becomes theirs free of all encumbrances and conditions.  

In other words, your grandchild can spend the money on anything they want to once they become old enough.   

You are able to manage the investments in the UGMA or UTMA account and can choose from a wide variety of investment options. You can also withdraw funds to cover expenses related to the welfare or education of the minor recipient. You can name yourself as the custodian of the account, although that does not change the irrevocable nature of the transfer. Another option is to have Seaside Wealth Management assist you in the investment management within the UGMA or UTMA accounts to help invest for your grandchildren. UGMA or UTMA custodial accounts are common vehicles for college savings plans. They allow you to build a dedicated account for your grandchildren. However, they are not my preferred way to save for college. We think 529’s are better for that. But first, let’s explore some key differences between UGMAs and UTMAs. 

UGMA vs. UTMA Accounts: Key Differences 

Both of these accounts are largely similar in operation and intent. However, there are a couple of key differences between UGMA vs. UTMA accounts. 

The primary difference between these two accounts is in the asset makeup of the account. An UGMA account is limited to purely financial products such as cash, stocks, mutual funds, bonds, other securitized instruments and insurance policies. An UTMA account, on the other hand, can hold any form of property, including real property and real estate. You could put your car into a UTMA account if you wanted, or the deed to a family home. 

The second key difference between UGMA and UTMA accounts is related to state adoption. All states have adopted the UGMA. On the other hand, Vermont and South Carolina do not allow UTMA accounts. You should examine state law carefully, as the specific implementation of both the UGMA and the UTMA can differ from state to state. 

UGMA vs. UTMA Accounts: Tax Implications 

UGMA and UTMA accounts are not tax-deferred assets (this is a big reason why we prefer 529 plans for college savings). All gains on investments are taxed as normal, and you may choose to pay these capital gains taxes on behalf of your grandchild. The parent or guardian may have to file a tax return on behalf of the minor and/or dependent child if the returns on the UGMA or UTMA account exceed the IRS’ income threshold. 

There are potentially some tax benefits to UGMA and UTMA accounts though. The details of the recipient’s dependency status and income define how the assets in UGMA and UTMA accounts are taxed. However, in many — if not most — cases, any returns in the account are taxed at the recipient’s tax threshold. Since the recipient is a child, this can translate to significant tax savings compared to if those gains were taxed at the parent’s (presumably much higher) income bracket.  

How UGMA and UTMA Accounts Could Impact Financial Aid  

When a college student applies for financial aid, the student and their family must complete the Free Application for Federal Student Aid (FAFSA), which determines their Expected Family Contribution (EFC). The EFC is a measure of a family’s financial ability to pay for college and is used to calculate the amount of federal and/or state aid a student is eligible to receive for college. 

Assets held in UGMA and UTMA accounts are considered the child’s assets, and as such, they can significantly impact the EFC calculation, and not in a good way. According to FAFSA guidelines, all assets in the name of the student can reduce aid and 20% of the asset’s value is taken for the EFC calculation. On the other hand, assets held by their parents are assessed at a maximum rate of 5.64% for their EFC. 

This means that funds held in a UGMA or UTMA account can reduce a student’s financial aid eligibility more than if the assets were held in a parent’s name. For example, if a student has $10,000 in a UGMA or UTMA account, their EFC would increase by $2,000 ($10,000 x 20%), potentially reducing their total financial aid package by the same amount.

Pros and Cons of UGMA’s and UTMAs 

Pros: 

1. Flexibility: the investments can be used to pay for college and they can also be used for anything else your grandchild wants or needs (down payment on a home) 

2. Simplicity: They are easy to set up and do not require any formal trust documents 

3. Tax Benefits: the first $1,100 of income is typically tax exempt and the next $1,100 is taxed at the child’s tax rate which is typically lower than your tax rate 

Cons: 

1. Not as tax efficient as 529’s when it comes to college savings: 529’s enjoy tax free growth and tax free distributions if the money is used to pay for qualified higher education. 

2. Loss of Control:

• When you contribute to an UGMA or UTMA you lose control of the money. You get to manage it until your grandchild gets to the age of majority, but that gift can not be taken back. Once it’s made, the money is technically the child’s. 
• The money can be spent on anything. If your grandchild wants to travel to Europe instead of going to college, they can do so with the money you put into an UGMA or UTMA. You can not stipulate what they spend the funds on. 

3. Can adversely impact financial aid: UGMA’s and UTMA’s can reduce the amount of financial aid your grandchild is eligible for. 

How to Minimize the Impact on Financial Aid 

Parents who have set up UGMA or UTMA accounts for their children may consider several strategies to minimize the impact on financial aid eligibility. One option is to spend down the assets in the account before the child reaches college age, using the funds for educational or welfare-related expenses. This can help reduce the account balance and its impact on the EFC calculation, but it won’t help much with college savings. 

Another strategy is to transfer the assets from a UGMA or UTMA account into a 529 college savings plan. Unlike UGMA and UTMA accounts, assets held in a 529 plan are considered parental assets, which are assessed at a lower rate for financial aid purposes (another reason why I prefer a 529 plan to the UGMA or UTMA for college savings). This can help preserve more financial aid eligibility for your grandchild while still providing a tax-advantaged way to save for college expenses. However, these funds might be taxed more heavily later if they aren’t all used on college expenses. 

What are 529 Plans? 

529 plans are tax-advantaged education savings accounts designed to help families save for future college expenses. These plans are named after Section 529 of the Internal Revenue Code, which governs their tax treatment. They are sponsored by individual states or educational institutions and come in two main types: prepaid tuition plans and college savings plans. 

Prepaid Tuition Plans: 

These plans let you pre-pay all or part of the costs of an in-state public college education. You may also convert them for use at private and out-of-state colleges. The Private College 529 Plan is a separate prepaid plan for private colleges sponsored by more than 250 private colleges. 

College Savings Plans: 

The 529 plan works much like a Roth IRA and by investing your after tax contributions in mutual funds. The 529 offers tax free growth and tax free distributions if the money is used to pay for qualified higher education. The Tax Cuts and Jobs Act also allows for 529 money to pay for private K-12 expenses as well as student loan repayments. Any leftover funds in a 529 plan can be used to fund a Roth IRA for your grandchildren in the future (once they start working). 

Pros and Cons of 529 Plans 

Pros: 

Tax advantages: One of the primary benefits of 529 plans is their tax treatment. Contributions to these plans grow tax-free, and withdrawals used for qualified educational expenses are also tax-free at the federal level. Additionally, many states offer state income tax deductions or credits for contributions. 

Flexibility: 529 plans allow for flexibility in terms of the beneficiary. If one grandchild decides not to attend college, the funds can be transferred to another eligible family member without incurring taxes or penalties.

High contribution limits: Unlike some other savings vehicles, 529 plans often have high contribution limits, allowing you to save a substantial amount for your grandchildren's education. 

Financial Aid Assistance: 529 plans may have a smaller impact on financial aid eligibility compared to UTMA and UGMA accounts, as they are considered the assets of the account owner, not the beneficiary. 

Control and Ownership: 529 plans provide you with more control and ownership over the funds, while UTMA and UGMA accounts transfer ownership to the child once they reach the age of majority. 

Cons: 

Limited investment options: While 529 plans offer a range of investment options, the choices may be limited compared to other investment vehicles. It's essential to consider the available investment options and their performance when selecting a 529 plan. 

Penalties for non-qualified expenses: If funds from a 529 plan are not used for qualified higher education costs there is a penalty to access them. The penalty is 10% of the withdrawal and the gains may be subject to federal income taxes at whatever rate the IRS would normally charge. 

The Bottom Line 

UGMA and UTMA accounts are types of custodial accounts, which allow you to store and protect assets for your grandchild until they reach the age of majority. Though similar in a number of ways, there are differences to consider when comparing UGMA vs. UTMA accounts. These boil down to the asset makeup of the accounts and state adoption, as not all states allow UTMA accounts. There are potentially some tax-related upsides to UGMA and UTMA accounts, but remember that these are not tax-deferred assets like some other types of college savings vehicles. 

We prefer the 529 plan when it comes to saving for college as they enjoy tax free growth and tax free distributions so long as you know the rules and use them to your advantage. There are several good 529 plans out there and if you have questions about them or would like to learn more please get in touch with me and we would be happy to share.

If you want to help your grandchild save for a down payment on a house or to purchase a new car then a UGMA account is excellent for that. On the other hand, if your goal is to help your grandchild pay for college, the 529 plan is best. Get in touch with us and we can help you think it through. 

This commentary reflects the personal opinions, viewpoints and analyses of the Seaside Wealth Management, Inc. employees providing such comments, and should not be regarded as a description of advisory services provided by Seaside Wealth Management, Inc. or performance returns of any Seaside Wealth Management, Inc. client. The views reflected in the commentary are subject to change at any time without notice. Nothing in this commentary constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Seaside Wealth Management, Inc. manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.