There are two types of accounts that can be set up for minors under the age of 18: 529 Education Accounts and Uniform Gift to Minors Act (UGMA) Accounts. The main goal for these accounts is typically for educational expenses, however funds from a UGMA account can be used toward the purchase of any items that are for the benefit of the child.
529 Plan:
- 529 Plans can be used for primary and secondary education expenses only. Compared to the UGMA, this type of account will give you more tax breaks, but it can ONLY be used for qualifying educational expenses for primary or secondary education. If your child goes to private school or you know your child plans to attend college, it’s a good vehicle. The 529 plan grows tax free and distributions come out tax free when used for education. Contributions can be tax deductible at the state level (for state supported 529 plans only). Earnings grow tax free and distributions are tax free.
- There are maximum contributions that can be made annually without the contribution counting against the lifetime gift tax exclusion. There are some caps on distributions per year for primary education, no caps for secondary.
- Unused funds for one minor can be passed on to another minor within the family (typically a sibling). The Secure Act 2.0, passed in January 1, 2023, now allows unused funds in 529 Plans to be converted to a Roth IRA for the minor.
UGMA Account:
- Unlike the 529 Plan, a UGMA account can be used for both educational expenses as well as any other items that benefit the child. This type of account does not have the same tax breaks as the 529 plan, but has more flexibility with distributions—for example funds can be used for summer camps, braces, instruments, etc. The account is in the child’s name where their tax bracket is typically zero. There is a cap for the first unearned income (gains) that is tax free, the next tranche of unearned income is taxed at the child’s tax bracket (zero). If there is a lot of gain in the account, it will be taxed at your tax bracket.
- There are no contribution limits nor distribution caps for a UGMA account.
- If the child is no longer a minor and there are unused funds, the child can then assume the account as their own or you can ‘gift’ the funds from the UGMA to the adult child for miscellaneous uses (down payment on a house, pay off a car loan, etc)
Funding a 529 Plan or UGMA Account
Funding can be provided by different parties. Accounts can be set up by a parent of the minor, grandparents of the minor, or other family relations. Contributions are often made by the custodian—the custodian is typically a parent or grandparent. The custodian can encourage others to make a ‘gift’ of a contribution to the account on birthdays, holidays, etc. Contributions can be made monthly (systematically investing) or in single sums. Often both the parents and the grandparents of the minor will make monthly or annual contributions.