Seven Reasons to Consider a UGMA Account Instead of a 529 Plan

For many parents, a 529 plan is a great way to set aside money for a child’s future education expenses: the money grows tax-deferred, and withdrawals are tax-free at both the federal and state levels, provided the funds are used for "qualified education expenses" (tuition, room & board, etc). Some states offer significant state tax benefits as well.

However, 529 plans come with some significant limitations, and aren't a perfect fit for everyone. In fact, depending on your situation, you may be worse off by tying up your child’s money in a 529.

An alternative to consider is the Uniform Gifts to Minors Act (UGMA) custodial account.  A UGMA account is a standard, taxable brokerage account that you open in your child’s name. Any money contributed to a UGMA account is considered an irrevocable gift: the funds legally belong to your child and cannot be taken back or used for your own personal expenses. You act as the custodian, managing their investments until your child reaches adulthood, at which point the account becomes completely theirs. 

While UGMA accounts don't explicitly offer the same tax benefits as a 529, they can often replicate those tax benefits if certain conditions are met, without limiting the money to educational uses.  They also provide some additional benefits that 529 plans are unable to offer.  

Below are seven reasons why a UGMA account might be a better choice for your family than a 529 plan.

Reason 1: You Want Your Child to Be Able to Use the Money for Non-Education Expenses

The biggest catch with a 529 plan is that any contributions must be used for education expenses. If your child decides to skip college to start a business, learn a trade, or join the military, your options for using the funds without penalty are limited. Even if your child does go to college, a 529 won't cover expenses like purchasing a car, flying home for holidays, or many other monthly living costs. 

If you withdraw 529 funds for non-qualified expenses, the recipient will owe ordinary income taxes plus a punishing 10% penalty on all the earnings. While it is possible to transfer unused funds to a sibling or roll them into a Roth IRA down the road, those maneuvers won’t help fund your child’s current non-education expenses, and come with their own strings attached.  

In contrast, funds in a UGMA account can be used for anything that directly benefits the child. There are no penalties for using it to buy a car, cover monthly living expenses, fund a gap year, or make a down payment on a home.

Reason 2: You Make Too Much Money for Your Child to Qualify for Financial Aid

One drawback of UGMA accounts is that they reduce your chances of receiving financial aid more significantly than 529 accounts. The FAFSA formula considers a UGMA a "student asset" and assesses it at 20% (meaning it reduces your financial aid eligibility by 20% of the account's total balance each year), whereas a parent-owned 529 is only assessed at a maximum of 5.64%.

However, for high-income parents, this drawback is irrelevant. Need-based financial aid is determined primarily by income, and because FAFSA weighs parent income so heavily, a household income above $175k or so will usually disqualify your child from grants at a typical in-state public university.  (If the child is headed to a private college, a household income of $250k+ will likely put them out of the running for financial aid.)  If your household income already disqualifies you for financial aid, the FAFSA's higher 20% penalty on UGMA assets won’t change your financial aid eligibility.

Reason 3: Your Child is Unlikely to Exceed $2,700 in Unearned Income per Year

One of the main benefits of a 529 plan is tax-free growth and tax-free withdrawals.  While a UGMA doesn't inherently provide either, you can still avoid paying taxes under certain conditions, particularly for modest balances and withdrawal amounts.

Many college students are subject to the IRS Kiddie Tax, which taxes their unearned income over $2,700 at the parents' higher tax rates.  However, if their unearned income (interest, dividends and capital gains) stays below $2,700, they can often avoid paying any tax. This is because their standard deduction shields the first $1,350 of unearned income from federal taxes, while the next $1350 (up to $2700) are taxed at the child's marginal tax rate. That tax rate generally drops to 0% if their investments are held for more than a year.  (Note: if their unearned income exceeds $1350, they generally must report it on a tax return, though parents can sometimes elect to include it on their own return.)

The following examples illustrate what level of account balances and embedded appreciation would keep you under that $2700 threshold to avoid paying tax, assuming 1/4th of the account is withdrawn each year (for a typical four year undergraduate degree).  They also assume a portfolio of broad-market index funds with a historical dividend yield of 2%, and a holding period of at least one year for any liquidated positions.

	Scenario 1: Modest Balance w/ High Appreciation	Scenario 2: Moderate Balance w/ Medium Appreciation	Scenario 3: Large Balance w/ Low Appreciation
UGMA Balance (Age 18)	$18,000	$32,000	$60,000
Portfolio Appreciation (Unrealized Gains)	50%	25%	10%
Estimated Dividends	$360 ($18k × 2%)	$640 ($32k × 2%)	$1260 ($60k × 2%)
Annual Withdrawal	$4,500	$8,000	$15,000
Realized Capital Gains	$2,250 ($4.5k × 50%)	$2,000 ($8k × 25%)	$1,500 ($15k × 10%)
Total Unearned Income	~$2,700	~$2,700	~$2,700
Federal Tax Owed	~$0	~$0	~$0

If you aren’t planning to set aside a massive amount of cash for your child, and you anticipate relatively modest annual withdrawals, with careful planning a UGMA account can effectively provide the same tax-free growth and withdrawals as a 529.

Bonus Strategy: If you are a proactive parent and are willing to do a five-minute chore every December, you can take advantage of this $2,700 limit every year, even before your child leaves home and starts to take withdrawals. This is done by selling and immediately repurchasing appreciated securities (aka tax gain harvesting) in order to generate $2700 in tax-free unearned income in the account.  This permanently steps up the cost basis in the account, and can wash away thousands of dollars in capital gains by the time the child reaches adulthood and starts to make withdrawals.

Reason 4: You want to take advantage of the American Opportunity Tax Credit (AOTC)

If the account balances and withdrawal amounts illustrated above seem too limiting for your situation, you can unlock additional tax-free growth and withdrawals by taking advantage of the American Opportunity Tax Credit (AOTC).

The AOTC provides up to $2,500 per year in tax credits for qualified education expenses.  To take advantage of the full credit, you need to pay at least $4,000 in tuition and fees. Unfortunately, since 529’s are already tax-advantaged, that $4,000 can’t be paid with 529 funds. Parents could claim the AOTC by paying the $4,000 from other sources, but since the AOTC phases out for married couples earning above $160k, most high-income parents are unable to take advantage of it.

However, if the parent chooses not to list the student as a dependent on their own tax return, the student can claim the AOTC on their own tax return. The credit can then reduce any income tax owed by the child, including the unearned income generated in their UGMA.  

The table below illustrates what level of UGMA account balances and embedded appreciation would keep the student’s tax bill under the $1500 nonrefundable portion of the AOTC.  As before, the examples assume a portfolio of broad-market index funds with a historical dividend yield of 2%, and a holding period of at least one year for any liquidated positions.  It also assumes the student has no other sources of income (such as a part-time job).

	Scenario 1: Modest Balance w/ High Appreciation	Scenario 2: Moderate Balance w/ Medium Appreciation	Scenario 3: Large Balance w/ Low Appreciation
UGMA Balance (Age 18)	$80,000	$140,000	$280,000
Portfolio Appreciation (Unrealized Gains)	50%	25%	10%
Estimated Dividends	$1,600 ($80k × 2%)	$2,800 ($140k × 2%)	$5,600 ($280k × 2%)
Annual Withdrawal	$20,000	$35,000	$70,000
Realized Capital Gains	$10,000 ($20k × 50%)	$8,750 ($35k × 25%)	$7,000 ($70k × 10%)
Total Unearned Income	$11,600	$11,550	$12,600
Kiddie Tax Exclusion	-$2,700	-$2,700	-$2,700
Income Subject to Parents' Tax Rates	$8,900	$8,850	$9,900
Gross Tax Exposure (15% Parents’ Rate)	$1,335	$1,328	$1,485
Non-refundable AOTC	-$1,500	-$1,500	-$1,500
Federal Tax Owed	~$0	~$0	~$0

As shown, if the parent is willing to forgo listing the child as a dependent on their tax return, and the student claims the AOTC on their own return, a UGMA account can effectively achieve the same tax-free growth and tax-free withdrawals of a 529, even for significant balances and withdrawal amounts.

As an additional bonus, if the student’s earned income covers more than half of their living expenses, they would qualify to receive the $1000 refundable portion of the AOTC.  Assuming the same tax situation above (a $1,500 tax bill), that $1,000 credit would be refunded to the student as free money!

Reason 5: You Want to Fund the Account with Appreciated Assets Instead of Cash

One limitation of 529 accounts is that they can only be funded with cash contributions.  This is unfortunate, because if you hold investments that have gone up significantly in value, giving your child actual shares of those appreciated investments instead of cash is one of the most powerful wealth-transfer strategies available. To understand why, it’s helpful to look at an example:

Let’s say you want to set aside $10k for your child’s future expenses. If you give your child $10k in cash, it costs you exactly $10k. But if you transfer $10k of highly appreciated stock into their UGMA instead, they still receive the full $10k value, while you avoid paying the capital gains taxes on that appreciation.  If your tax liability was, say, $2k, you have effectively reduced the true cost of your gift down to $8k.  Looking at it another way, you received an immediate 25% return on your gift!  

Now, your child will still have to pay capital gains tax when they sell your gifted investment.  But as described above, they can avoid paying taxes on those gains if their unearned income (which includes those gains) stays below the $2700 kiddie tax limits, or their total tax bill stays below $1500 and they claim the AOTC.

Funding a UGMA account with highly-appreciated assets allows you to supercharge your contributions by eliminating the taxes you would otherwise have to pay on them.  With proper tax planning, your child can then sell those shares, realize those massive gains, and owe $0 in federal taxes on them. 

Reason 6: You Live in a State That Offers Limited or No State Tax Benefits

One reason to consider using a 529 is if your state offers a significant tax deduction or credit for contributing to it. Unfortunately, many states offer no tax benefits for 529 contributions, while many others only offer modest benefits:

• No state tax benefits: Roughly a quarter of states, including California and Texas, offer no state tax benefits for contributing to a 529. If you live in one of these states, a 529 gives you no state tax advantage over a UGMA.

• Limited benefits: The majority of states offer some limited state tax deductions that might save you a few hundred dollars in state taxes. These are a nice perk, but may not be enough to offset the 529's limitations and fees.

• Generous benefits: A few states, including Colorado, allow you to deduct the full amount of your contribution. A few other states, like Utah and New York, offer very high deduction caps or strong tax credits.

Note: Even if your state offers tax benefits, the ongoing fees of a 529 account can significantly erode those benefits over time. This is because a state tax deduction is a static, one-time benefit based on your initial contribution, while 529 administrative fees (often adding 0.15% to 0.30% annually) create an annual, compounding drag on your growing balance. For example, while a $25,000 contribution might net you a $1,000 upfront tax deduction, an extra 0.25% in annual 529 fees on that growing investment will completely erase that $1,000 advantage in about ten years.

Reason 7: You See Your Child Gaining Full Control of the Funds as a Positive

The final reason to consider a UGMA account over a 529 is that you embrace its core feature: transferring ownership and responsibility of the funds to the child. While a 529 keeps the parent in the driver's seat forever, a UGMA account provides an opportunity to empower your young adult to step up and practice real-world financial management using the foundation you've built for them.

A common hesitation with UGMA accounts is the fear of handing an 18-year-old a massive pile of cash. However, in most states, the child does not gain control of the account at age 18, but rather age 21 or beyond, after the child has had a few more years to mature.  Technically, the parent’s custodianship ends and the child gains full access to the money at the age of majority in the state where the account was opened: 

• Age 21: This is the standard age of majority in the vast majority of states.

• Age 25: Many states allow you to delay the transfer up to age 25.

• Age 18: Only nine states default the transfer to age 18. However, most of these states, including California, allow you to delay the transfer until ages 21-25.  Very few states force the transfer at age 18 with no option to delay.

By the time your child actually takes the reins at age 21 or 25, they are more likely to have progressed through college or started a career, and to have developed the maturity necessary to use those funds responsibly.

A Hybrid Approach: Using a 529 and a UGMA Together

It is important to remember that this isn't a strict "either/or" decision. Some affluent parents choose to open both accounts to build a more secure financial runway.

Why manage two different accounts? Ultimately, it comes down to hedging your bets and acknowledging that every financial tool requires a compromise. If you go all-in on a 529 plan, your compromise is flexibility; you risk locking up your capital and facing harsh 10% penalties if your child chooses a non-traditional path. Conversely, if you go all-in on a UGMA, your compromises are the limitations on tax-free growth, and the loss of control when your child reaches the age of majority.

By splitting your savings, you hedge against both risks. You can rely on the 529 as your tax-fortified vault for traditional education expenses, and the UGMA as your flexible reserve for everything else.  If you want to blend the two strategies, here are a few popular ways to do it:

• Split by Expense Type: Use the 529 for the heavy, qualified educational costs (tuition, room, and board). Simultaneously, fund the UGMA to cover everything the 529 legally cannot: a reliable used car, a study abroad, etc.

• Split for State Tax Benefits: If you live in a state with generous 529 tax benefits, fund the 529 plan up to the maximum state tax deduction limit each year (being careful not to overfund beyond anticipated future education expenses). Afterwards, direct any additional annual savings into the flexible UGMA.

• Split by Account Size: Fund a UGMA so that the income it generates remains under the limits described above (the kiddie tax limit, the single standard deduction, the AOTC). Then, redirect any additional contributions into a 529 plan to maximize tax-free compounding (again, being careful not to overfund beyond anticipated future education expenses).

• Split by Contributor: Grandparents often prefer the safety and control of a 529 plan because they want to guarantee their gift is used for education. Allow the grandparents fund the 529, while you (the parents) fund the UGMA to provide the flexible life-launch money.

Summary: When You Should Lean Towards a UGMA Account

A UGMA might be the superior tool for your family if you can check off most of these boxes:

▢ You value maximum flexibility: You want the funds available for any life path, not just higher education.

▢ You’re a high-income earner: Your income already disqualifies your child from need-based financial aid.

▢ You have a modest savings target: The income from the UGMA is likely to stay under the $2700 kiddie tax limits

▢ You want to leverage the AOTC: Your child’s income will allow them to claim the $1500 tax credit.

▢ You prefer to gift appreciated assets: You want to maximize the value of your contributions by reducing your tax exposure.

▢ You live in a low-benefit state: Your state offers limited tax benefits for 529 contributions.

▢ You like the transfer of ownership: You see handing over control as a positive and empowering milestone for your young adult.