Host: Dave Specht, Family Dynamics National Development Manager, Wells Fargo Private Bank
Guest: Karen Josephson, Senior Wealth Planner, Wells Fargo Private Bank
It’s hard to predict future college costs or even how technology may change what college will look like 10 years from now. If you are just starting to think about an education fund because your children or grandchildren are still young, how do you best plan for these education costs?
I’m Dave Specht, Family Dynamics National Development Manager for Wells Fargo Private Bank, and this is “Your Financial Journey,” a podcast series that explores questions that families of wealth commonly face. I am joined today by Karen Josephson, Senior Wealth Planner at Wells Fargo Private Bank.
Karen, we’ve seen college costs continue to rise and the whole nature of college may, at some point, be disrupted. In such an environment, what should parents consider when determining whether to invest in a custodial account such as an UTMA or a 529 Plan?
Well, Dave, if you’ve got a few years before your kids are ready to start college, then the 529 Plan is an option that’s very popular and also widely used. With this type of plan, you contribute after-tax dollars, which can then potentially grow tax-free. So the earlier you start saving, the more you can potentially benefit from this compounded tax-free growth.
Another attractive feature of the 529 is that you can frontload up to 5 years’ worth of annual gifting into the plan. So instead of being limited to $15,000, which is the annual exclusion for gifting for 2019, according to the IRS, you can contribute up to five times that amount, or $75,000.
But keep in mind that this would require you to file a gift tax return and you’d be limited over the next five years for gifts to that same beneficiary. And also if you were to die within that five-year time period, a portion of the gift may be included in your taxable estate.
The one thing to note, Karen, is that withdrawals are tax-free as well, but only if you use them to pay for qualified education expenses for the beneficiary of the account—like your child or grandchild. Otherwise, the withdrawals or the earnings may be subject to a 10% penalty or taxes. Is that correct?
Yes, Dave, that is correct, which is why some parents or grandparents prefer the flexibility of a custodial account called an UTMA, also known as the Uniform Transfers to Minors Act. With an UTMA, parents can transfer funds and other property to their children without having to create a formal trust. That said, the 529 plan and the UTMA are flexible in different ways. For example, the funds in an UMTA belong to the child and can be used for more than just education purposes, whereas the 529 plan belongs to the account owner, who can change the beneficiary, but the use of the funds is limited to qualified educational expenses.
I can see the pros and cons of both. I’m sure most of us love the idea, Karen, that the 529 plan potentially grows tax-free and the withdrawals are tax-free. This can really help grow that education fund. But on the other hand, UTMAs have more flexibility in how the funds are used. So how do you determine the right approach?
While both accounts can be used for college savings, there are three key differences between the UTMA and the 529 Plan that parents should consider:
This first is what are the tax implications. Since UTMAs are considered the child’s assets, a portion of the earnings are exempt, and then a portion may be taxed at the child’s rate called the Kiddie Tax. In contrast, the earnings on a 529 plan can potentially grow tax-free and also the qualified withdrawals are exempt from federal taxes.
The next thing to consider is who controls the account. For an UTMA, the parents or custodian of the account control it only until the child reaches the age of majority (which varies from state to state). At that point, neither the parents nor custodian has a say in how these funds can be used since the gift is irrevocable. Whereas with the 529 plan, the account owner controls the plan and if the beneficiary no longer needs the education funds, the owner can change the beneficiary to another qualified family member.
Finally, the third thing to consider is the impact on college financial aid. The child is considered the owner of the UTMA account, which may reduce the child’s ability to qualify for financial aid. But with the 529 plan, the assets are not owned by the child and therefore not counted as part of the resources for determining financial aid.
Those are important considerations, Karen. What specifically would you recommend our listeners do as they think about the best approach for their specific circumstances?
I would suggest having a conversation with their financial and tax advisors about how the assets likely will be used, as well as the tax implications. If you want the assets earmarked for educational purposes only, then the 529 plan may be a good option. However, if you want to use the assets as part of a broader gifting strategy, the UTMA account would provide more flexibility.
Karen, thanks for sharing your perspective. There are a lot of things to consider there. Thank you to our listeners for joining this podcast.