Helping your teen embark on their college experience entails a host of decisions more important than which mini fridge to purchase or what color shower caddy to choose. For parents, one of the primary decisions is how to fund the tuition bills.
Hopefully you’ve been diligent in preparing for the costs of college. There are several types of accounts you might have contributed to over the years in order to accumulate college savings. If you have balances in both types of custodial accounts (UGMA and UTMA) and section 529 plans, which should you draw upon first to begin funding your child’s higher education? (For more, see: Student Loan Debt: What Every Borrower Should Know.)
Custodial accounts represent completed gifts to your child. Funds can be consumed for a wide range of uses, not just college costs, But they must be for the benefit of the child named on the account. You can’t withdraw the funds for the benefit of another child.
Conversely, section 529 plans are more flexible in who can benefit from the balance, but are more limited in how you can spend it. You can only use 529 balances to pay educational costs. However, the funds can benefit the child named on the account, another child or other family members (unless the plan was funded from a custodial account). This flexibility is particularly useful if you have more than one child and you might need to maneuver funds to cover college tuition balances at different times.
Control of a custodial account transfers to the named beneficiary at either age 18 or 21, depending upon the state in which you live. Accounts are typically "locked" and your child becomes the signatory agent to complete all transactions once they reach the specified age. If you have concerns about your child gaining full control of custodial funds at such a young age, it might make sense to use up custodial accounts first when funding college obligations. (For related reading, see: Youth and Roth IRA Equals a Solid Retirement Plan.)
If you contributed to a 529 plan, you retain control of the account at all times. This allows you to make all investment and distribution decisions, regardless of your child’s age.
Custodial account transactions are typically taxable, to the extent that income and capital gains are generated. The taxable impact of maintaining or selling a custodial account should always be considered, both in terms of your own tax liability and with regard to any potential application for student aid (see below).
If your child incurs qualified higher education expenses during the year, all withdrawals from a 529 plan are tax-free.
If you’re pursuing a financial aid application, the value of custodial accounts count more heavily toward the calculation of parental contributions, as compared to section 529 plans. This could sway you to consume custodial accounts first, depending upon your total income, taxes and other considerations.
We typically recommend using assets held in your child’s name or in a specified college savings account, before consuming your personal savings. The one exception to this principle is if your goals include significant legacy and wealth transfer planning. The scope of your financial assets, your family structure and your legacy objectives should be carefully evaluated prior to making any asset funding decisions. (For more, see: How to Build a Credit Report for Your Adult Child.)
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