529 vs. Child's Trusts

Because of the high cost of college, many parents start saving for their children's education when they are infants, hoping to build sufficient reserves to pay tuition and other expenses. The most popular forms of college saving are 529 plans and trust accounts. Each has advantages and disadvantages, and you need to choose the system that's best for you and your child.

A 529 college savings plan is set up under state laws. All 50 states have some form of 529 plans, although they differ slightly. None provides any federal income tax deduction, although many states with income taxes allow deductions from those taxes. You can set up a 529 plan for each of your children and contribute up to your state's mandated limit.

For example, in Texas and California, there are no annual contribution limits, aside from the fact that contributions above $15,000 can potentially subjected to gift taxes. As a general rule, there are no federally mandated 529 contribution limits in place.

The major disadvantage of a 529 plan is that it is college savings. The money can be used only for higher education tuition and related expenses. A child who doesn't go to college can't really benefit. Any 529 money withdrawn for purposes other than higher education is subject to a 10 percent penalty. However, interest earned by the 529 investment is tax-exempt.

There are two basic trust account plans, Uniform Gift to Minors Act and Uniform Transfer to Minors Act. They are similar, but UGMA is primarily to hold securities while UTMA can hold other assets. Both are formed as custodial trusts under state laws with an account to hold savings for children.

A trust account provides more flexibility for withdrawal because it is not strictly limited to higher education expenses. It also must be managed by a trustee or custodian, normally a parent, but the assets revert to the child beneficiary at age 18 or 21 — this varies by state and in some circumstances can be extended to age 25. Earnings also are subject to income tax.

Funds in either a 529 plan or a trust account are treated as assets of the parent when calculating a student's eligibility for financial assistance in college. With a UGMA or UTMA trust account, there's no way to guarantee that the child beneficiary will spend the money on education. A custodial trust, however, could invest in a 529 plan to restrict spending to college.

Another alternative is a gifting trust, an irrevocable trust set up with the child as beneficiary. These must be drafted by a lawyer. One type provides for assets to be held until the child is 21 but usually cannot restrict withdrawals after that age to college purposes. A gifting trust also must file an income tax return each year and pay taxes on earned income. The trustee named to control the trust is responsible for filing a tax return; any tax is paid with trust funds.

UGMA or UTMA custodial trust accounts can affect eligibility for grants and other financial aid because they count as assets for the student, even if a minor, while 529 funds are assets of the parent. If this is a problem, you can liquidate the custodial account and put the money into a 529 account. Irrevocable trust funds are assets of the trust, not an individual, until they are distributed so they should not affect aid applications. They also are not restricted to student aid.