UTMA/UGMA vs. 529 Plans: What are the key differences?

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

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

There's no limit on 529 distributions for most qualified higher education costs. Still, 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. You'll need to check with each state to see if state tax will be applicable.

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.

"If your primary goal is to invest for education, 529 plans offer the greatest mix of tax advantages, control and flexibility"

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 related beneficiary if the first child doesn't need all the money," 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 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 $15,000 gift tax exclusion. If you give more than that 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, which in 2021 amounts to $75,000 (or $150,000 for a married couple electing to split gifts) without paying gift taxes. 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.