WRITTEN BY: Autumn Lax, CFP® AIF®
New parents and grandparents are often eager to start helping out their kids and frequently ask this question,
“What is the best way to start saving for my child?” 🤔
While there is no one right or wrong answer, the type of account you choose could make a big difference! 👀
This article will break down two of the most common savings vehicles for children.
Below we’ll discuss the 529 college savings plan and a type of custodial account known as the UTMA or UGMA.
Before diving into which account to start saving in, I would start by asking yourself: What are you saving for?
- Do you want to save specifically for college?
- Do you just want a pot of money available that you can hand over to their child as a way of getting them started off in life?
👉 Option 1: Saving to an UTMA/UGMA Account
First, what are UTMA/UGMA accounts and what do they actually do?
The acronyms, UTMA and UGMA stand for Uniform Transfer or Uniform Gift to Minors Act. These are a type of custodial account used as a means for transferring property to a minor.
You can set one up at any financial institution just like opening a savings account, but there are some very important rules governing the UTMA/UGMA that you’ll want to pay particular attention to.
✅Key facts about UTMA/UGMA accounts:
- Money placed into a UTMA/UGMA account is an Irrevocable gift. Meaning the money can’t be taken back and the money has to be invested and used for the exclusive benefit of the minor.
- The beneficiary becomes the owner at the time of gift. Since this occurs while they are still a child, someone has to manage or oversee the funds.
- The person to oversee the funds is known as the Custodian of the account. This is usually the parent, grandparent or guardian.
- Once the child reaches age of majority, either 18 or 21 depending on what state you live in, the custodian is required to give the funds over to the child and the money becomes theirs to use in any manner they wish. If you are the beneficiary of a custodial account, make sure you are familiar with these rules because your financial institution…or parent… may not proactively reach out and give you the money on your 21st birthday, you’ll likely have to contact them and request to have it transferred into your own account.
Funding a custodial account is easy and there is no limit to how much you can put into a UTMA/UGMA.
Since it is a gift, those gift tax rules will kick in if you exceed the annual limits.
How will saving to a UTMA/UGMA for your child’s education affect financial aid? 🤔
Another consideration is that money in a UTMA/UGMA affects financial aid differently than other savings accounts because the money belongs to the child, not the parent. Child assets are treated different on the FAFSA, something I’ll talk more about in a minute…so keep this in mind. Also, any income earned off the account is considered “unearned income” of the child and only the first $2200 is taxed to them. Amounts over this limit, which could be from capital gains, interest or dividends, are taxed to the parent.
If you want to set aside money for your child or grandchild that isn’t earmarked for a specific purpose, the UTMA/UGMA custodial account may be for you. Unlike the 529 college savings plan, money in a Custodial account does not have to go towards anything in particular. This flexibility is also a double-edged sword, however. As the rules state, you must hand over the money when the child reaches age of majority and that may not be when you feel they are financially ready. One thing I hear parents say a lot when they gift money to their kids… they want it to be used for something big/important not just “spent away”. An example would be a down payment on a first home, car, wedding ring, etc… but with the UTMA/UGMA you can’t really make that call. You can have the convo with your children but if they decide to go against your wishes, pull the money out and party in Cabo…well…they can.
Child trust accounts can be set up if you want further control over the assets but those come at the cost of drafting a trust document with your estate attorney.
The UTMA/UGMA is generally a simple and cost-effective way to start, provided you are comfortable with the parameters outlined above.
Be wary of transferring money from a UTMA/UGMA into a 529 college savings plan as the money retains its irrevocable nature and will be placed in a special “Custodial 529”. This means you lose the ability to change beneficiaries down the road like you would in a traditional 529. With all that said, let’s dive into the pros and cons of funding a 529 college savings account.
👉 Option 2: Saving To a 529 College Savings Account
Hands down the most common concern I hear parents say when we talk about the 529 college savings plan is hesitancy towards funding something that is so limited or specific. What if my child doesn’t go to college? What if they get a scholarship or choose a less traditional type of schooling? Well, the 529 may be more flexible than you think…let’s look at the various ways you can maximize this savings tool!
A major benefit of the 529 college savings account is that money grows tax deferred and comes out tax free, if used for qualified education expenses.
So, what is considered a “qualified expense”? 🤔
- College tuition and fees,
- Up up to $10k for k-12 tuition, books, computers,
- Up to $10,000 in student loan payments
These are just a few of the most common eligible uses for money in a 529.
A law recently passed allowing up to $10k from your 529 account to be used towards k-12 education.
This is a great option since daycare & preschool costs these days feel almost as expensive as a college education. Or, for parents considering private school, you now can set aside money specifically for that purpose. While this might sound like a smart strategy, the big advantage to having money in a 529 is tax free growth.
If the account hasn’t had time to grow, putting money in and taking it right back out may not yield as much benefit as it’s worth.
Keep this in mind if funding for early education is your primary goal.
How will saving to a 529 College Savings Plan for your child’s education affect financial aid?
As we discussed earlier, assets owned by the child and parent affect financial aid differently.
Financial aid eligibility is based on a student's financial need, but money in a 529 savings plan counts as the parent’s asset. With regard to the FASFA, student owned money could cause a 20% reduction in aide eligibility while parent owned assets have much less of an effect, with only a maximum reduction of 5.64%.
A unique feature of the 529 plan is the ability to pre-fund 5 year’s worth of gifting.
Important for those with considerable assets, family members can spread their annual gift tax amount over 5 years but pre-fund the account all at once. With the current gift tax allowance at $15k per year, this would mean a gift of $75k (5 years’ worth) at one time without going over their gift tax allowance. Be sure you consult with your financial, tax and estate planning professionals to know if this is the right strategy for you.
✅ Here are some additional benefits to the 529 college savings plan.
- One parent/custodian owns the funds. This means you are always in control of what happens with the money, even if your child doesn’t end up going to college or needing the money
- You can change beneficiaries, within certain limits. This means if child #1 doesn’t go to college or gets a scholarship but child #2 needs extra money for grad school, you can move the money around as long as it stays in your family.
- Legacy planning. There is no limit on how long money can stay in a 529 plan. If your kid doesn’t go to college or gets a full ride scholarship, let the money stay in the account and grow tax free. They can then use it for their future children!
- Anyone can contribute to a 529. So set one up for your new baby and let grandparents, aunts, and uncles, even friends gift money towards your child’s college education!
Written by Autumn Lax, CFP
The views expressed are the views of Drucker Wealth Management, and are not necessarily those of Hornor, Townsend and Kent, LLC(HTK). The information provided is for educational purposes only and is not intended as investment advice or a solicitation for the purchase or sale of any product or security. Investing involves risk, including the potential loss of the money you invest. Insurance and other financial products and services may be subject to certain terms, eligibility requirements, conditions and costs. Lance Drucker is a Registered Representative and Registered Investment Adviser of Hornor, Townsend & Kent LLC, (HTK), Registered Investment Advisor, Member FINRA (www.finra.org) / SIPC (www.sipc.org). 2 Park Ave, Ste 300, New York, NY 10016. 212.681.0459. Drucker Wealth Management and other listed entities are not affiliated with HTK. HTK does not offer tax or legal advice. Always consult a qualified professional for specific information regarding your personal situation.