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JANUARY 25, 2021

What's the difference between 529s and custodial accounts like UTMAs and UGMAs?

Answered by
Richard Polimeni
Director, Education Savings Programs, Bank of America
First, the similarities: 529 plans and custodial accounts — such as a UGMA (Uniform Gifts to Minors Act) or a UTMA (Uniform Transfers to Minors Act) — provide ways for parents and others to help pay children's tuition and other expenses for college, and private elementary and secondary school.
One big difference: Custodial accounts also can be used for non-education purposes, whereas a 529 plan can be used (without adverse income tax consequences) only to cover qualified education expenses.

Other key differences between 529 plans and custodial accounts include:

  • Tax-advantaged savings
  • Ownership and control of the funds
  • Allowable contributions and investment options

Comparing the tax advantages

529 plans have the tax edge over UTMA and UGMA accounts: "A 529 allows your investments in the plan to grow tax-free, and withdrawals used for tuition, room and board, and other qualified education expenses also are not taxed," says Richard Polimeni, director, Education Savings Programs at Bank of America.
"If your primary goal is to invest for education, 529 plans offer the greatest tax advantages, control and flexibility"
— Richard Polimeni, Director, Education Savings Programs, Bank of America
There's no limit on 529 distributions for most qualified higher education costs, but only $10,000 a year per beneficiary can be taken tax-free from all 529 accounts to pay that beneficiary's elementary and secondary school tuition expenses.Footnote 1
UGMAs and UTMAs have fewer tax advantages than 529 plans. Generally, the first $1,100 of annual unearned income is tax-free, and the next $1,100 is taxed at the child's tax rate. Unearned income above $2,200 is taxed at the rates for the child's parents which may be higher than the child's rate.

Who controls each of these savings accounts?

If you want to make sure the money you've saved for education expenses is actually used for that purpose, a custodial account probably isn't for you. With a UTMA or UGMA custodial account, parents or others who set up the account decide how to invest the assets and how distributions are used — for school expenses or anything else that benefits the child. But when kids reach the age of majority (typically 18 or 21, depending on the state), they gain control and can spend the money however they like.
"For 529 accounts, the owner who opens the account keeps control regardless of the beneficiary's age, and can switch to another beneficiary if the first child doesn't need all the money," Polimeni says. This flexibility, along with the tax savings, makes 529s especially popular for education purposes.

What are the rules on contributions and investments?

Custodial accounts provide much more flexibility: They can be funded with any combination of cash and investments — normally, stocks, bonds, mutual funds, and so forth — although UTMAs also allow contributions of real estate, art and patents authorized by the account's owner, or custodian, who is most commonly a parent or guardian of the minor for whom the account was set up. Ownership, however, is transferred to the minor once he or she reaches the age of majority. The custodian also has wide latitude to invest assets in the account.
Only cash contributions are allowed for 529 plans, and investment options are limited to those created for the particular 529 plan. However, 529 investment options have come a long way over the years, and most plans offer a wide variety of investment options to meet the needs of families investing for education.
529 plans have maximum account balance limits that can range from $300,000 - $500,000, however, annual contributions to a 529 plan aren't otherwise limited. But any amount you give to a beneficiary will be part of your annual gift tax exclusion. If you give more than the current limit to the beneficiary's 529 account, or if you make other gifts to the beneficiary in the same year, the excess contribution or other gifts will count against your lifetime federal gift tax exemption or be subject to federal gift tax. However, there's an exception: The IRS lets you give five years of contributions at once, without paying gift taxes. There are limits that apply, which can be found in the Annual Limits Guide (PDF). Note that if you do this, you will have used up your annual exclusion for that beneficiary for that five-year period, and other gifts to that beneficiary made during that time may count against your lifetime federal gift tax exemption or be subject to federal gift tax. Note that if you die before the end of the five-year period after the initial gift, a portion of the initial gift may be included in your gross estate for federal estate tax purposes.

When would someone choose a custodial account over a 529 (and vice versa)?

To sum up, if your primary goal is to invest for education, 529 plans offer the greatest tax advantages, control and flexibility. Custodial accounts can be good options to transfer wealth for just about anything else.
If you want to make a contribution but aren't sure if it will be used for education, the safest bet would be to put it in a custodial account. You or the beneficiary can move funds from a custodial account to a 529, but you can't do the opposite without adverse income tax consequences.
Help when you want it
Merrill, its affiliates, and financial advisors do not provide legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.
Footnote 1 To be eligible for favorable tax treatment afforded to the earnings portion of a withdrawal from a section 529 account, such withdrawal must be used for "qualified higher education expenses," as defined in the Internal Revenue Code. The earnings portion of a withdrawal that is not used for such expenses is subject to federal income tax and may be subject to a 10% additional federal tax, as well as applicable state and local income taxes. The additional tax is waived under certain circumstances. The beneficiary must be attending an eligible educational institution at least half time for room and board to be considered a qualified higher education expense, subject to limitations. Institutions must be eligible to participate in federal student financial aid programs. Some foreign institutions are eligible. You can also take a federal income tax-free distribution from a 529 account of up to $10,000 per calendar year per beneficiary from all 529 accounts to help pay for tuition at an elementary or secondary public, private or religious school. For distributions taken after December 31, 2018, qualified higher education expenses now include expenses for fees, books, supplies, and equipment required for the participation of a designated beneficiary in an apprenticeship program registered and certified with the Secretary of Labor under the National Apprenticeship Act. They also include amounts paid as principal or interest on any qualified education loans of the designated beneficiary or sibling of the designated beneficiary, up to a lifetime maximum of $10,000 per individual. Distributions with respect to the loans of a sibling of the designated beneficiary will count towards the lifetime limit of the sibling, not the designated beneficiary. Such repayments may impact student loan interest deductibility. State tax treatment may vary for distributions to pay for tuition in connection with enrollment or attendance at an elementary or secondary public, private or religious school, apprenticeship expenses, and payment of qualified education loans.

Before you invest in a Section 529 plan, request the plan's official statement from your Financial Solutions Advisor and read it carefully. The official statement contains more complete information, including investment objectives, charges, expenses and risks of investing in the 529 plan, which you should consider carefully before investing. You should also consider whether your home state or your beneficiary's home state offers any state tax or other state benefits such as financial aid, scholarship funds and protection against creditors that are only available for investments in such state's 529 plan. Section 529 plans are not guaranteed by any state or federal agency.

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