529 Essentials: 529s vs. Trusts

This week, we will compare and contrast 529s and Trusts for the purpose of college financial planning.

Two Basic Types of Investment Vehicles Designed for Intergenerational Wealth & Education Planning: 529 plans and Trusts. Both investment types allow families to save money for children and grandchildren. In this article, we will be specifically referring to Uniform Gifts to Minors Act (UGMA) and Uniform Transfer to Minors Act (UTMA) custodial accounts when we refer to Trusts. While the two types of trusts are very similar, one main difference is that UGMA limits gifts and transfers to bank deposits, securities and insurance policies while UTMA allow almost any kind of asset to be transferred to a minor. Also, UGMA accounts can generally be used until the beneficiary is 18 or 21, while UTMA accounts can be used until 25 years old. While 529s are dedicated investment vehicles for saving and paying for higher education, UGMA and UTMA assets are available to the minor when they reach age of majority per state law and can be used in any way including higher education. Given the complexity of the issues, you as an advisor can provide value by knowing these differences and selecting the right investment vehicle based on the unique needs of your client.

Market Sizing: As of December 2015, 529s allowed 12.7 million families to save over $253 billion in assets based on data by Strategic Insight. Of that, 11.6 million families saved over $230 billion in 529 savings plans while 1.1 million saved over $23 billion in 529 prepaid accounts. In addition to the $253 billion in 529s, Coverdells allowed families to save approximately $43 billion in assets as of December 2015 for the goal of college financial planning per survey data reported in the Strategic Insight 529 Industry Analysis 2016 report. Together families have saved an estimated $296 billion in 529s and UGMA/UTMA accounts for college financial planning as of the end of 2015.

Compare and Contrast:

—Account Control: 529s allow the accountowner to maintain control of the account, and allow for an unlimited number of rollovers if the beneficiary is changed to a member of the family of the previous beneficiary. Therefore, 529s allow changes in beneficiaries while the accountowner maintains control of the account. In contrast, the beneficiary’s parent or guardian maintains control of the UGMA/UTMA account for the benefit of the child until the beneficiary reaches age of majority which varies by state. The parent or guardian has a fiduciary responsibility to manage the account in the sole best interest of the child. As such, the beneficiary of the UGMA/UTMA account cannot be changed. Therefore while 529 assets are revocable, UGMA/UTMA assets are irrevocable transfers.

—Contributions: For residents in over 30 states plus D.C., 529 accountholders receive a state tax deduction or credit for contributions into a 529 plan in addition to other benefits and incentives. Contributions into a UGMA/UTMA do not have state tax benefits on contributions. Also, while 529 plans do have maximum contribution limits, UGMA/UTMA accounts do not have a limit.

—Tax Benefits and Age Restrictions: 529 assets grow tax deferred and are distributed tax exempt when used for qualified higher education expenses, and there are not any age restrictions. UGMA/UTMA custodial accounts do not grow tax deferred and are subject to an annual tax. While the first $1,050 of unearned income in 2016 is not taxed, the second $1,050 is taxed at the child’s rate. Unearned income over $2,100 is taxed at the higher of the child’s or parent’s tax rate when the beneficiary is under age 18 and taxed at the child’s tax rate when over age 18. That age of 18 can increase up to 23 as of the end of the tax year if the child was a full-time student and the income didn’t exceed half of the child’s annual expenses. IRS refers to the tax on investment income for the minor as the “kiddie tax.”

—Qualified Expenses: 529 savings plans can be used for any qualified higher education expense such as tuition and fees, books, supplies and computer technology. Non-qualified distributions from 529s can be made, though the earnings portion will be subject to tax and a 10% penalty. There are a list of exemptions to this 10% penalty, as covered in a prior 529 Insider “529 Essentials” column. UTMA/UGMA accounts can be used in any way at the discretion of the beneficiary, as they are the asset of the beneficiary. Therefore the children receives the assets whether or not they go to college.

—Financial Aid: UGMA/UTMA assets increase EFC by 20% and distributions from the account increase EFC by 50%. In contrast, 529 assets increase expected family contribution (EFC) up to 5.64% and distributions from 529s do not impact EFC.

—Investment Changes: While 529s within and outside of UTMA and UGMA accounts are granted two investment changes per year, UTMA/UGMA assets not invested in a 529 do not have a limit.

—Cost: The cost to set up and maintain a UGMA/UTMA is considerably higher than a 529, due to accounting, legal and custody fees.

—Custodial 529 Accounts: Once the assets are in a UGMA/UTMA custodial account, one way to avoid the annual tax expenditure is to invest the assets in a custodial 529 account as assets grow tax deferred in 529s. Also, contributions to 529 plans are considered completed gifts, and so are taken out of the taxable estate after. Lastly, an additional benefit of investing the assets in a UGMA/UTMA into a 529 account is improved impact on financial aid, as the assets decrease its impact on EFC from 20% to 5.64% or less. Despite these benefits, 529s must be funded with cash which means the assets in the trust must be sold which may create a taxable event. Lastly, do note the 529 plan assets remain irrevocable and so the beneficiary of the account cannot be changed. This aligns with the guardian maintaining its fiduciary duty for the account, and the control of the account will still change to the minor when they reach age of majority.

Therefore, advisors, accountants and estate planners should understand the key product features of 529s and Trusts, how the two types of investment vehicles function independently and ensure the most appropriate investment vehicle is used for your clients given their specific needs.

Next week, we will compare and contrast 529 savings plans and 401(k)s and IRAs.