I get approached by many people with small children and newborns who ask, “what should I be doing to save for college?” At the end of the day, it’s a more complicated question than you think. If I had a crystal ball and could see exactly who your child would grow up to be, what they’d want to do with their life, the appropriate schooling level, which schools, and what the market will do between now and when they graduate, I would be able to give an answer with certainty. As things are, we must plan and make some assumptions.
According to the Education Data Initiative, average costs of college are $36,436 per year in the United States, including all expenses. What’s the problem with planning from this data? Depending on the funding vehicle you use, there can be consequences that can come with both undershooting the actual costs and overshooting the costs. While there are many investment vehicles you can use for college funding, I will only be focusing on two common ones today. This is a discussion of using a 529 College Savings Plan versus a Uniform Transfers to Minors Account for college funding, pros and cons, and when each may be appropriate.
529s
One of the most popular college savings vehicles today is known as a 529 College Savings Plan. Here’s how it works:
- You and/or others contribute money (up to $17,000 per year or $85,000 upfront) after taxes.
- The money grows tax deferred.
- If the funds are used for qualified education expenses, you take the funds out tax-free.
- If you meet certain criteria, the 529 beneficiary may be able to convert up to $35,000 of unused funds into a Roth IRA over their lifetime.
- 529s can be transferred to members of the immediate family of the beneficiary.
Because of the tax-advantaged nature and the recently announced additional flexibility, I see many people contributing very high amounts to these plans, particularly in major metropolitan areas. However, there are some drawbacks to be aware of:
- 529s count against Free Application for Federal Student Aid and can prevent the beneficiary from qualifying for student aid.
- 529s can be subject to IRS audit.
- 529s have limited investment options.
- Education-related withdrawals prior to college are limited.
- Non-qualified withdrawals are subject to state and federal income taxes on the gains, plus an additional 10% IRS penalty.
If one family member decided to front-load a 529 plan at your child’s birth with $85,000 and the plan earned a hypothetical 10% return for the 18 years until college, the plan would have $472,592.97. If your child opts to go to undergrad and/or graduate school and spends it all on qualified expenses, that total is tax free. Let’s say at 18, your child is a prodigy and opts to skip college entirely to start a company. They may be eligible to convert $35,000 still but removing the 529 funds would result in significant taxes and penalties on the $352,592.97 in gains. Because of this risk, I warn people about the risks of vastly over-funding a 529. Saving in an investment account without tax advantages may put someone in a better situation than the scenario described.
Here are instances where a 529 may be appropriate:
- Your child has already shown or said that they would like to go to college.
- You know how much you want to be able to contribute to college and don’t plan to overshoot that goal.
- You have multiple children who could be college bound.
Uniform Transfers To Minors Accounts
Uniform Transfers to Minors Accounts (UTMAs) are accounts that are started for the benefit of a minor child and become the asset of the child once they reach the state’s age of majority, which would be 18 or 21 depending on the state. Although seen by most as a college funding vehicle, these accounts come with some versatility that you would not see in a 529.
I know this couple who love their children dearly but having kids at home 24/7 in the summer takes a toll on both their mental health and their marriage. They asked if they could utilize 529 funds to cover the expense of sending their kids to summer camp so they could have some respite. Unfortunately, they could not. If they had a UTMA account, they could have.
Here are some key differences between UTMAs and 529s:
- UTMAs can be used for expenses on behalf of the minor prior to the minor reaching age of majority.
- Once the minor reaches the age of majority, they can use the funds for any purpose.
- UTMAs are subject to a kiddie tax on income and gains, meaning that to a point, the assets would be taxed at the child’s tax bracket instead of the tax bracket of the parents.
- Individuals could contribute many asset types, including cash, securities, and properties.
I often tell parents, particularly in a state with the age of majority of 18, it’s important to know you can trust your kid with the responsibility of handling money for themselves. If you think the minor would spend all the funds on a car instead of using it for education, you may want to consider an option where you have the control.
Conclusion
With college being such a potentially high expense, many parents are left wondering which funding option will work best for their family. Both 529s and UTMAs have merits when used appropriately, and drawbacks if things don’t go according to plan. Consulting a financial professional about you and your family’s unique situation can help you make the decision that meets your needs.
This informational and educational article does not offer or constitute, and should not be relied upon, as financial or investment advice. Your unique needs, goals and circumstances require the individualized attention of your own financial and other professionals whose advice and services will prevail over any information provided in this article. Equitable Advisors, LLC and its associates and affiliates do not provide tax or legal advice or services.
Cicely Jones (CA Insurance Lic. #:0K81625) offers securities through Equitable Advisors, LLC (NY, NY 212-314-4600), member FINRA, SIPC (Equitable Financial Advisors in MI & TN) and offers annuity and insurance products through Equitable Network, LLC, which conducts business in California as Equitable Network Insurance Agency of California, LLC). Financial Professionals may transact business and/or respond to inquiries only in state(s) in which they are properly qualified. Any compensation that Ms. Jones may receive for the publication of this article is earned separate from, and entirely outside of her capacities with, Equitable Advisors, LLC and Equitable Network, LLC (Equitable Network Insurance Agency of California, LLC). AGE-5917600.1(09/23)(exp.09/25)
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