Looking to start investing on behalf of your children? You’ve got a lot of options to consider, but make no mistake, choosing any one of them is better than choosing none at all.
Should you open a Coverdell Education Savings Account (ESA)? How about a 529 plan? Maybe a Uniform Transfer for Minors Act Account (UTMA) or Universal Gifts to Minors Act Account (UGMA), sometimes better known as a custodial account where minors can receive gifts without the aid of a trustee (i.e., parent or guardian).
This article walks through ESA vs. 529 vs. UTMA accounts so you can have a better understanding of which make the best type of investment account to open for your children.
As a note, I crafted this article in conjunction with UNest founder and CEO Ksenia Yudina in a Q&A format. She is also a CFA (Chartered Financial Analyst). The responses found within should answer questions you may have related to ESAs, 529 plans and UTMA and UGMA accounts.
What is a UTMA or UGMA?
UGMA and UTMA accounts are essentially the same thing with rules around what you can gift to minors. These accounts are tax-advantaged custodial accounts for kids that enables parents and other family members to invest and save for more than just college.
Funds in the UTMA and UGMA accounts can be used for future goals such as but not limited to buying a first car, down payment on the house or a wedding day.
The custodian of a UTMA or UGMA account can be a parent, grandparent, relative, or friend and use money to invest for a kid who serves as the account’s beneficiary. Each UTMA or UGMA account is set up and managed by its custodian until the child is of age. The custodian picks at what age the beneficiary will take control of the account. These assets remain in the name of the account beneficiary.
Depending on the family’s state, this is normally between 18 and 25. UNest Investment Account for Kids makes it easier than ever before for families to receive the benefits of UTMAs.
Up to $2,200 in annual earnings in UTMA grow in a tax-advantaged way. The first $1,100 of the earnings is completely tax-free. The next $1,100 is taxed at the child’s tax rate. Anything exceeding $2,200 is taxed at the parents’ tax rate.
This threshold is applicable to gains in the account and not to the original contributions.
What is a 529 Plan?
A 529 plan is a tax-advantaged savings plan that encourages parents to save for their child’s future education costs. 529 plans are offered by states, state agencies, or educational institutions. Each state sponsors at least one type of 529 plan.
If you use funds on unqualified educational expenses from your 529 plan, you will lose your tax advantages and the earnings portion becomes subject to a 10% penalty.
You can invest in almost any state 529 plan, not just your own state’s 529 plan. This plan can be used to pay for college costs at any qualified college, nationwide.
In most plans, your choice of college is not affected by the state that sponsored your 529 college savings plan. For example, You can be a California resident, invest in an Oregon plan and send your child to college in Texas.
What are the Key Differences Between UTMA/UGMA and a 529 Plan?
Both 529 plans and UTMA/UGMA custodial accounts provide a tax-advantaged way for parents and others to help save for a child’s tuition and other educational expenses.
UTMAs and UGMAs offer a significant benefit to parents looking for a flexible way to save for all the future life stages your child will experience. This may or may not include education.
This flexibility is especially important since children may end up not going to college or receive financial aid or scholarship. If the account holder uses funds on unqualified educational expenses, in a 529 plan, they lose their tax advantages and the earnings portion is subject to a 10% penalty.
Additionally, a UTMA/UGMA account is a federal product and is not attached to the state. States sponsor 529s and each has its own plan. One major distinction for UTMAs and UGMAs from 529 plans is the inability for you to transfer a designated beneficiary’s UGMA or UTMA account to another person.
In effect, the minor designated as the account beneficiary owns the assets within these accounts and they cannot be reassigned to another person like with a 529 plan.
Lastly, in 529 plans, you face limited investment choices like mutual funds and index funds. Further, you can only change asset allocation twice a year. In UTMAs, parents can use these investing apps for minors to pick individual stocks, alternative investments and even crypto currency.
Stated simply, you have more control on the portfolio allocation throughout the year.
What is a Coverdell ESA Plan?
A Coverdell education savings account acts as a tax-deferred trust account. These accounts are created by the U.S. government to provide assistance to families looking to save for future education expenses for account beneficiaries. In this case, children.
To qualify, the beneficiaries must be 18 years old or younger when establishing the account. While you can set up more than one ESA for a single beneficiary, your maximum annual contribution for one beneficiary amounts to $2,000.
Is a Coverdell ESA the Same as a 529 Plan?
Up until a few years ago, Coverdell ESAs held a distinct advantage of 529s: account rules allowed parents to use the funds they saved for a broader range of education costs. Whereas with 529 plans, funds could only have their funds go toward college-related expenses.
You could also apply a Coverdell ESA’s funds to other education fees such as tuition costs at a private high school. Tax reform in 2018 eliminated this distinction. Despite this change, ESAs do still offer more options for account holders when opening this type of investment account and the types of investment vehicles they contain.
Which is Better? 529 Plan or ESA or UTMA/UGMA
For the majority of families, a UTMA account easily makes the most sense. In contrast to 529 and ESA plans that can only go toward qualified educational expenses, you can use the funds you invest in UTMAs for any expense that benefits the child named on the account.
If an account holder uses funds from a 529 plan for non-education related expenses, they lose tax advantages and the earnings become subject to a 10% penalty. Parents using UTMAs have the flexibility to plan and save ahead for all the important life stages that their children will experience — college, first car or a down payment on the home.
In addition, parents have more control of what they can save and invest in, while you have limited investment choices in 529 and ESA accounts.
Depending on where you open your 529 or ESA, you can confront voluminous amounts of paperwork. The whole process of setting up a 529 account takes an average of eight hours, with only a limited chance that the selected program is aligned with their requirements and situation.
In contrast, the a UTMA like one from UNest makes it easy for families of all income levels and backgrounds to set up and manage savings and investment plans for their kids.
UTMA account holders can also receive gifts for their children’s custodial accounts from family and friends.
What are the Advantages & Disadvantages of a 529 Plan or Coverdell ESA?
The limited flexibility of 529 and ESA accounts is at the heart of both their advantages and disadvantages. On the one hand, by limiting the use of the funds saved only to education, 529s and ESAs can reduce the likelihood that a family will be tempted to use the money for other less-worthwhile purposes.
For most families, this limitation is not realistic as they look to make investments in their child’s future. This results in the disadvantage of being forced down a single track by 529s and ESAs. Because of their limitations, 529 plans can carry the advantage of offering minimal options.
How Can I Get Started with a College Savings Plan?
You have three main ways to start with a college savings plan for your kids.
- You can reach out to a financial advisor in your area or online through services like Stash or M1 Finance with an UTMA account. Alternatively, you can open a 529 plan through a service like Vanguard.
- You can go to each state’s website and go through a lengthy application process to establish an account using the state’s sponsored 529 plan.
- Lastly, you can download the UNest app and open a custodial account in five minutes from your phone. UNest is a registered financial advisor but is powered by technology and therefore has an automated, affordable and efficient set of processes.
UNest demystifies the previously complex process of setting up saving plans for education and other essential life stages with a paperless approach. It just takes five minutes to set up an ongoing, prudent investment plan for your kid’s future.
Your portfolio adjusts as the market changes. You can ‘set and forget’ and let the tech do the work as you invest early with compounding returns that build your kids future. No need to use the best stock research and analysis apps when your portfolio automatically follows the markets and adjusts with market changes.
UNest also includes a simple gifting feature that makes it easy for family and friends to contribute to a child’s UNest account.
This feature directly helps parents ask friends and family to contribute to helping their children achieve their dreams rather than receiving a toy that will most likely be played with once and never seen again.
These contributions toward buying what otherwise is free stocks can add more fuel to the compounding fire.
What are Some Other Apps to Save Money for Future Expenses?
There are other money apps for kids like Backer, offering the Utah 529 plan and EarlyBird, offering UTMA. Both of these options haven’t yet reached the maturity level or exponential growth of the UNest app and don’t bring the experience of the financial advisors or financial industry experts.
In addition, other fintech apps have pretty convoluted onboarding processes that take users on average 20-30 minutes to sign up and lack some essential in app functionality.
About the Site Author and Blog
In 2018, I was winding down a stint in investor relations and found myself newly equipped with a CPA, added insight on how investors behave in markets, and a load of free time. My job routinely required extended work hours, complex assignments, and tight deadlines. Seeking to maintain my momentum, I wanted to chase something ambitious.
I chose to start this financial independence blog as my next step, recognizing both the challenge and opportunity. I launched the site with encouragement from my wife as a means to lay out our financial independence journey and connect with and help others who share the same goal.
I have not been compensated by any of the companies listed in this post at the time of this writing. Any recommendations made by me are my own. Should you choose to act on them, please see the disclaimer on my About Young and the Invested page.