Everyone knows that college is expensive, and tuition only seems to increase. If you have children, you have surely wondered about the best way to finance their future education.
As with everything in finance, there are a wide array of options. Among the most common is the UTMA (Uniform Transfers to Minors Act). In this post, we examine this option and compare it with another - the 529 plan - and see which offers a more holistic investment for your children's future.
UTMA (Uniform Transfers to Minors Act)
We have stayed away from using UTMA's and don’t really see it as the best available option for funding a child's education. We typically see this strategy with physicians 45 or older as it was traditionally the suggested preference of financial planners, but we see its use declining and is now almost non-existent with younger physicians.
The reason is in the details:
Contributions to an UTMA are an irrevocable gift to the child, which means you lose control of those dollars once you give them, and they can never be returned. If you pile a good bit of money in the account and the child catches wind that this money is theirs for the taking when they turn 21, they may choose to go to a local community college or no college at all in order to receive a larger amount of money at age 21. If this account is being used to fund a child’s education but is not needed because the child chooses a different path that is less expensive, are unmotivated because they want the money, or they get their college fully paid for by scholarships, the amount of money they receive at 21 could be sizable, and they can use it for anything.
I’ve seen what money can do to people and I’m just not interested in the possibility of my kid receiving $250,000 at age 21. The primary reason people do it is because the income is taxed at the child’s rate. This is the case after age 18, but you pay taxes on any income from the trust account at the parents marginal tax rate on anything over $1,900 per year while they’re younger than 18. Also, common misconception, but contributions are not deductible.
After 18, the income from the account would be taxed at the child’s rate but if the dollars were in a 529 Plan, you wouldn’t pay taxes on any distributions or income. The 529 Plan remains in the name of the parents, which means the child doesn’t have ownership at a specific age, and the funds must be used for education-related expenses such as vehicles, tuition, room and board. This allows you to pay for these expenses with dollars that are not taxable at all when distributed, maintain control, requires that the funds be used for their intended use, and prevents the kids from getting Vegas money at 21. If a child gets a scholarship, the parent can withdraw funds equal to the amount of the scholarship without being penalized but would have to pay federal and state taxes on the earnings portion.
THE 529 PLAN
For this reason, we typically recommend the 529 Plan be used for funding 50%-60% of the expected need. As long as the child isn’t a part-time student, you can withdraw funds tax-free to pay for several expenses that scholarships don’t normally cover such as supplies, car, computer, apartment, furniture, etc… You can also transfer the leftover unused funds to be used by the next kid, or use it for graduate-level education expenses.
The other portion that may be needed will normally come from your Roth IRA assets. You’re able to get money into a Roth IRA through the back-door Roth conversion rules. The earnings in a Roth IRA are tax-free and avoid penalties if withdrawn after age 59 1/2. But one exception is if they’re used for qualified education expenses.
THE ROTH EXCEPTION
Withdrawals from IRAs, including Roth IRAs, are actually exempt from withdrawal penalties if the funds are used specifically for qualified education expenses, including tuition, fees, books, and room and board. These funds can be used to supplement the 529 plan if needed when the children are in school. If they aren’t needed, then the funds can be used in later years for retirement.
WHAT'S BEST FOR YOUR CHILD?
UTMA is always an option, but we don’t think it’s the best strategy if we can structure a situation where you can remain in control of the money, deter a child from being spoiled or unmotivated, and avoid taxes altogether on the growth. Physicians are often pitched that UTMA's are the greatest because you pay the child's tax rate when you withdraw the money. But if the intended use of the money is for education expenses, you can avoid paying taxes completely.