By Cindy Alvarez, Senior Wealth Management Advisor
Helping families design their financial roadmap often involves a discussion on some of the best practices for setting money aside for children’s education. The tough part for parents is first trying to determine if their child is going to be college bound, community college bound, trade school bound, or perhaps none of the above while they are busy learning the alphabet, learning their colors, and learning to tie their shoes. What if you start saving for college and you find out that your child has other plans?
Most parents of young children have heard of college savings plans known as “529” plans but may know very little about the plan design and associated tax benefits. Two main benefits of a 529 plan are: tax free growth on the investments held in the account and, in some plans, (state) tax deductible contributions. Another benefit is when you’re in the qualifying process for financial aid, a 529 plan versus traditional savings improves your chances of receiving aid. Any assets held by a child will carry a liability in the financial aid application (FAFSA) evaluation, however, funds in a 529 are considered the parents funds and not subject to the same scrutiny on the FAFSA. We will discuss this more later.
These 529 plans were originally designed to help fund higher education for college bound students. But recent legislation has allowed 529 plans to also fund K-12 tuition (limits apply), accredited trade schools, and 2-year accredited community colleges. This provides more options for those who have contributed to a 529 plan and the path of education changes.
So, what if you are in the beginning stages of planning for your children’s future and you feel too much uncertainty to commit to a 529 plan?
There is another alternative called the Uniform Transfer to Minors Act (UTMA) and this type of savings account brings a different set of benefits to minors that may prove a better fit for some households. UTMA accounts are considered custodial accounts, meaning they are owned by the child, but remain under the custody of the adult. These accounts can be used to pay for education, but have more flexibility in terms of how these funds can be spent. Simply put, the assets in an UTMA can be used for virtually anything – as long as it is “for the benefit of the child.” There is only one exception being parental obligations such as food, clothing, and shelter.
If you feel unsure about making a commitment to a 529 when your children are young, the UTMA is a good alternative. In some cases, families will create both accounts where the funds can be leveraged. To help make the decision between a 529 and an UTMA, it is important to understand the different tax advantages that are associated with both types of accounts.
As previously mentioned, the 529 plan offers tax free growth. This means when it comes time to withdraw from the account to fund qualifying educational expenses, any market growth or “gains” from the investments are non-taxable. Also, if you file taxes in the state where the 529 plan is held, your contributions are likely deductible on your state tax filing on an annual basis. It is worth investigating as you evaluate 529 plans.
The tax advantages are far different on an UTMA. First and foremost, any contributions to an UTMA are not tax deductible. UTMA accounts are subject to what is known as a “kiddie tax” where if the child’s unearned income from the interest and dividends in the account are below $2,200 per year, you’ll pay taxes based on the child’s tax bracket, which is for most people, low or even nothing at all. Any additional earnings over $2,200 are taxed at the parents’ marginal tax rate. Here’s a quick way to calculate:
Child’s net earned income + Child’s net unearned income – Child’s standard deduction = Child’s taxable income
Worth noting, the first $1,100 of the child’s unearned income is tax-free, and the next $1,100 is subject to the child’s tax rate, likely 10%.
You may be asking yourself “what size of an UTMA account produces more than $2,200 of unearned income?” This depends on what you’re invested in and how much those investments earn. For a moderately balanced portfolio valued at roughly $35,000 and comprised of both stocks and bonds, one could anticipate $2,100 of unearned income. The gains in the account may not be realized each year so the unearned income could show up less, but at some point, these gains will be realized when the funds are needed.
If you’re thinking that from a tax perspective, UTMA accounts are not as favorable as a 529 plan, you would be correct. With that said, the taxes on an UTMA will not present a terrible tax outcome in most cases and it provides some taxable benefit should your child not pursue post-secondary education.
UTMAs and 529 plans are alike in terms of their high contribution limits. Both are $15,000 per year ($30,000 for married couples). Any overage amount is subject to Federal Gift Tax.
So, when is an UTMA account NOT your best option when you ARE pursuing post-secondary education? These accounts count as student assets, and as previously mentioned, FAFSA applications first look at student assets to draw down first when financing their educations. UTMA accounts are weighted at 20% in FAFSA calculations while 529 plans, when owned by a parent, are weighted at 5.64% – at the highest. In short, UTMA accounts can negatively impact your financial aid awards.
UTMA accounts are good choices when you have pre-college expenditures that benefit your child, such as private school and extracurricular activities, such as sports. They also provide more flexibility in terms of how they are invested. This could present more positive outcomes on portfolio performance. And, providing you are in a higher income tax bracket, this could save you tax dollars on the earnings when you consider the “kiddie tax.”
It is important to understand that any funds remaining in an UTMA account when a child comes of age, age 21 in most states, the account transfers to the child and you are no longer the custodian of this account. This could be an opportunity to educate your children on the benefits of saving and investing, and it gives them a start on their financial journey.
Tax and financial planning professionals can assist in helping you make a well-informed and appropriate choice. Please contact us today to discuss your options.