Withdrawal Rules for Different Types of College Saving Accounts

Withdrawal Rules for UTMA, UGMA, Section 529 Plans, and Coverdell ESAs

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There’s no doubt that desperate times often call for desperate measures, and for many households, times are getting desperate. With prices rising everywhere from the gas pump to the checkout line, many parents are wrestling with whether or not they can tap their kids’ college accounts to help make ends meet.

When it comes to the rules and penalties for withdrawing college funds for non-college expenses, every account is slightly different.

Here’s a breakdown of the rules, laws, and taxes associated with the three most popular college accounts:

  1. UTMA and UGMA Custodial Accounts
  2. Section 529 Plan Accounts
  3. Coverdell Education Savings Accounts

UTMA and UGMA Withdrawal Rules

One of the oldest and most often used college accounts, especially before Section 529 plans were invented, are the UGMA and UTMA custodial accounts. These accounts allow adults to make a financial gift to a minor, and also name someone (including themselves) as the custodian of the account.

The important word here is “gift.” The money in these accounts, once given, is the legal property of the minor. The custodian’s job is to keep it safe and invest it wisely, so that the minor could benefit from it someday.

While that sounds strict, the rules define “benefit” fairly liberally. UGMA and UTMA accounts are often used to pay for college, but can also be used for any expense the minor incurs.

This can include anything from basics costs of living to leisure activities like teams sports. You just have to be able to prove that the minor directly benefited from the use of the money.

Taxes and Penalties on UTMA and UGMA Withdrawals

Any profits made on the liquidation of investments in a child’s UGMA or UTMA account are reported on the child’s tax return.

Some or all of this might be included on the parent’s tax return, at the parent’s tax rate, depending on how the family files their tax returns.

There are no IRS penalties on taking money out of a UGMA or UTMA account. However, it is possible that the investments purchased may have a surrender charge or exit fee if held less than a certain amount of time.

Section 529 Plan Withdrawal Rules

More money has flowed into Section 529 accounts in the last few years than into custodial (UGMA / UTMA) accounts over the last decade. Because of that, it wouldn’t be surprising if some cash-strapped parents now wish they could get some of their money back.

Luckily, Section 529 accounts were designed to allow parents to retain more control than the UGMA and UTMA accounts. At any time, someone who has contributed to a Section 529 account can choose to access their money for any reason. They do not have to worry about explaining it to anyone, and it does not have to be for the benefit of the child.

Taxes and Penalties on Section 529 Withdrawals

Money that is withdrawn from a Section 529 plan that is not used for higher education expenses will be subject to a 10% penalty and income tax on the profits.

For example, if you put $10,000 into a Section 529 plan that is now worth $15,000, you’d have a $5,000 profit. If that entire amount is withdrawn for non-college purposes, you’d have to pay income tax and a 10% penalty on the $5,000 gain.

Additionally, the underlying investment may charge you a surrender fee. If you were sold a Section 529 Plan by a full-service stockbroker and you have “B” or “C” class mutual fund shares, you’ll likely get hit with a surrender penalty.

Coverdell Education Savings Account (ESA) Withdrawal Rules

The non-college withdrawal rules on the Coverdell ESA fall somewhere between the Section 529 Plan rules and the UGMA / UTMA rules. They are considered a gift to that child but can be rolled over to another child if the first doesn’t have qualifying education expenses by age 30.

Better yet, you don’t have to use this account only for college costs. While you can’t use it for food or clothing like you can with a UGMA or UTMA account, you can use it for other educational costs before college. These costs can include K-12 private school tuition, tutoring, books, school uniforms, and technology (a computer or laptop).

So, if you are tight on money and have a Coverdell ESA, you’d be better off to take a withdrawal from the account for high school tuition or school uniforms, than to spend the money out of your own pocket.

Taxes and Penalties on Coverdell ESAs

If the money is used for “qualifying” educational expenses, the money can be withdrawn completely tax-free. If it is not used for qualified education, the portion of the distribution that represents a gain is taxed to the beneficiary (child) as income and subject to an additional 10% penalty.

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