Looking beyond the 529 plan for college savings

Many parents have come to understand from the day their children are born that college is both necessary and very expensive.

While it's assumed that a 529 college savings plan is the best way to save for that education, there are other options to be explored.

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To be clear, 529 plans allow parents—and anyone else who's interested—to contribute up to $14,000 per person without incurring a gift tax into an account that will grow tax-deferred and can be withdrawn tax-free if it's used for qualified educational expenses. Moreover, the money can be used for the educational expenses of a sibling or a relative without penalty.

These are all tremendous advantages, but they do not come without drawbacks. One other option is to consider Uniformed Gift to Minors Act/Uniform Transfers to Minors Act accounts, which differ from a 529 plan in several ways.

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For starters, the 529 plan has limited investment options, which can hinder the construction of a diversified portfolio. In addition, the existing portfolio can only be altered once a year (new contributions can be placed in different options). UGMA/UTMA accounts, on the other hand, can be invested in any exchange-traded fund, individual stock or bond that the custodian (parent) finds appropriate.

Should interest rates increase, bonds held inside a 529 plan may decline in value. There would also be limited protection against fat-tail events or geopolitical meltdowns that managed futures, precious metals and real estate investment trusts mitigated during previous market crises.

Keep in mind that savings held inside a 529 plan cannot be used for high school education or other expenses that arise before college.

Parents ultimately may decide that their savings would be better spent on a top academic high school that increases their child's chance at receiving a college scholarship or being better prepared in the classroom. Others may choose high schools with competitive athletic programs.

Conversely, UGMA/UTMA accounts do not have time limitations; the only requirement is that the proceeds be used for the benefit of the child.

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It's very important to note that upon reaching the age of majority under a state's UGMA/UTMA law—usually 18 or 21, depending on the jurisdiction—the child (minor) gains control of the assets and may use them as he/she sees fit. This is unlike the 529 plan, so irresponsible children could potentially misuse the funds.

While a 529 plan allows the investments to grow tax-deferred and be taken out free of federal taxes to pay for a qualified educational expense, the UGMA/UTMA accounts make the first $1,000 of investment income tax-free, while the second $1,000 is taxed at the child's rate. Everything above $2,000 is taxed at the parent's marginal rate until the child reaches the age of 18.

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Given the low capital gains rate and initial investment, the different structures are generally negligible from a tax standpoint.

The assets held inside a 529 plan count as parental assets and are assessed at a maximum 5.64 percent rate in determining the student's Expected Family Contribution for federal financial aid. Meanwhile, UGMA/UTMA accounts are considered assets of the child and are assessed at a rate of 20 percent against the EFC.

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A year before applying for financial aid, however, the custodian can transfer the UGMA/UTMA account to a UGMA/UTMA 529 plan so the income is not reportable to the child. The latter account is reportable on the Free Application for Federal Student Aid, not as a student asset assessed at the usual 20 percent student rate but as a parental asset at the lower, 5.64 percent maximum parental rate.

It should also be mentioned that 529 plans for all children are considered assets of the custodian and may impact financial-aid eligibility, unlike the UGMA/UTMA accounts.

"While the 529 plans are a great avenue for many families, it's important to know there are other ways to reach your goals."

In an effort to mitigate capital gains exposure, the parents can maximize the allowable tax-free investment income to increase the cost basis over time, as the UGMA must be liquidated before making the transfer. UGMA/UTMA accounts, therefore, are more suitable for the hands-on investor.

The UGMA/UTMA approach would allow the account to be invested in alternative assets or well-researched individual equities that serve to further diversify the account under a more competitive fee structure without negatively impacting the child's financial-aid package.

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Nevertheless, all financial decisions are of a personal nature and warrant a thorough examination. While the 529 plans are a great avenue for many families, it's important to know there are other ways to reach your goals.