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When it comes to paying for their children's education, baby boomers have moved the 529 Plan to the head of the class. A recent survey conducted by global asset management firm AllianceBernstein found that, among 700 parents planning to pay for at least some of their children's college education, 529 Plans led the way with 39 percent. UGMA and UTMA accounts, also known as custodial accounts, were a distant second, at eight percent. Coverdell Education Savings Accounts accounted for just five percent.

The trend isn't particularly surprising, according to Joseph Hurley, founder and CEO of savingforcollege.com and author of "The Best Way to Save for College: A Complete Guide to 529 Plans." He said that since 529 Plans gained tax-free status in 2001 – meaning that earnings on 529 Plans are federal income tax-deferred and distributed federal tax-free – the only thing keeping 529 Plans from becoming even bigger is the public's lack of knowledge about the savings accounts.

"College is expensive, and the 529 allows your child to stay for the full cost of college without paying taxes," Hurley said. "I believe we'll see continued growth of 529 Plans since there are so many American families that should be using these plans but aren't, currently. It strikes people as the kind of thing you can put off until tomorrow."

Hurley is quick to point out that the tax advantages of 529 Plans are offset, slightly, by the fact that their management fees are higher than those of, say, custodial accounts like UGMA and UTMA. Still, those expenses are far outweighed by the tax advantages.

A custodial account is the worst kind to have for school savings.

- Joseph Hurley, CPA

 

Before the invention of 529 Plans back in 1996 and their subsequent tax-free status, in 2001, Uniform Gift to Minors Act (UGMA) and the Uniform Transfers to Minors Act (UTMA) accounts – originally designed as a way of passing on property to children without an attorney needing to set up a special trust fund – had become a nifty way of saving money for a child's school needs.

Essentially, the Acts allow a person to fund an account for a child but limit that child's access to the account until he or she reaches maturity age (usually 18 or 21, depending on the state). Legally, the child owns the account, but the parent or guardian is named custodian, which means he or she actually controls the money until the child grows up. Two big advantages of such an arrangement are that whatever income earned from the account is taxed at the child's rate and that there is no maximum contribution to such an account. (Coverdell ESAs have a contribution limit of $2000, up from just $500 in 2002.)

But the disadvantages, particularly when compared to 529 Plans, are readily apparent: First, the income is subject to tax (albeit the lower tax of the child's rate); second, there is a fee charged if the money is withdrawn for any reason other than what is considered to be in the best interests of the child; and third, no custodial restrictions can be placed on the account, meaning if the child reaches majority age and decides he or she wants to use it buy a Corvette convertible instead of attend college, the parent has no legal recourse.

Another disadvantage of UGMA/UTMA accounts is that, since custodial accounts are considered assets of the child, the child's financial aid eligibility is impacted.

"In that case," Hurley said, "a custodial account is the worst kind to have for school savings."

Making the Switch

With UGMA/UTMA accounts on the outs and 529 Plans on the rise, can a parent switch over?

Technically speaking, yes, but there are certain conditions: First, when the child reaches majority age, he or she will be the sole owner of that 529 Plan. This is because while taking money out of the UGMA/UTMA account and transferring it into a 529 Plan reflects the interests of the child, that money still is the sole property of the child, who gets it all when he or she reaches maturity age.

In other words, you can take the money out of the custodial account but you can't take the custodial account out of the money.

To learn more about preparing for your child's higher education needs, click here.