Planning for college is complicated enough. Throw a long term education savings plan into the mix and the proverbial can of worms is now open. From 529s to Coverdell ESAs to UTMA accounts and UGMAs, there is plenty of confusion to go around.
A good place to start is eliminating the types of accounts that are not specifically geared toward education. This leads us to the UTMA and UGMA. These accounts are short for Uniform Transfer to Minors Act and Uniform Gift to Minors Act. For simplicity sake, we’ll just refer to them as UTMAs.
UTMA accounts are a way to gift money to minor children. Contributing funds to a UTMA constitutes an irrevocable gift (a.k.a no take-backs). Once the funds are given, they must be managed for the benefit of the minor and you cannot change the beneficiary. However, there is a lot of flexibility with this type of account. The custodian (usually Mom or Dad) can decide what is in the best interest of the minor (little Jack or Jill). According to Vanguard’s website, these accounts “allow you to save on behalf of a child for education or any other purpose that benefits the child (other than parental obligations such as food, clothing, and shelter).”
Many parents lean toward UTMAs because they have an out if expenses come up prior to college that could benefit their child. The flexibility of UTMAs make them attractive, but it reminds me of the old expression about having your cake and eating it too. While the desire for flexibility is understandable, the decision to go with an UTMA can have serious drawbacks.
The funds in the UTMA are taxed at the minor’s rate up to a certain limit and then taxable at the parents rate. They are also subject to capital gains tax treatment when investments are sold to eventually pay for education expenses. Because UTMAs are taxable accounts, investment returns will be limited compared to a 529 College Savings Plan which allows tax free growth. This is the same concept of investing in a Roth IRA for retirement versus saving for retirement in a regular taxable investment account.
UTMA Accounts – Planning For College
Another important drawback of UTMAs involves how the funds are treated when applying for financial aid. UTMA assets are considered to be owned by the minor (student) and can reduce financial aid eligibility. This is in contrast to funds held within a 529 College Savings Plan. 529s are considered to be a parental asset and are treated more favorably when determining eligibility.
This is not a comprehensive description of UTMAs or 529 College Savings Plans but it is an important place to start. I’m also not suggesting that UTMA accounts are bad. They’re just not the best fit for a college savings plan. Recognizing that there are special accounts designated for specific purposes can help you stay on track.