Withdrawal Rules for Different Types of College Saving Accounts

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

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When finances become tight in a family, some parents begin to think about accessing money they put into college savings accounts to help make ends meet. They might not be aware of how much money is available through federal financial aid, or they might not want to take out federal student loans in the future to cover costs, but what can they do when money is needed immediately for non-college purposes?

A decision of this type is not to be made lightly as it could affect your child’s ability to pay for college. But if money is desperately needed, parents need to be aware of the different rules and tax implications for withdrawing college funds for non-college expenses from UTMA and UGMA Custodial Accounts, Section 529 Plan Accounts, and Coverdell Education Savings Accounts.

UTMA and UGMA Withdrawal Rules

UGMA and UTMA custodial 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 will benefit from it someday.

UGMA and UTMA accounts are often used to pay for college, but can also be used for any expense the minor incurs—anything from basic costs of living to leisure activities like team sports. The custodian must be able to prove that the minor directly benefits from the use of the money.

There are no IRS penalties on taking money out of a UGMA or UTMA account, but the investments purchased may have a surrender charge or exit fee if held less than a certain amount of time. Profits made on the liquidation of investments in a child’s UGMA or UTMA account are generally reported on the child’s tax return, but some or all might be included on the parent’s tax return, at the parent’s tax rate, depending on how the family files its federal taxes.

Section 529 Plan Withdrawal Rules

Section 529 accounts were designed to allow parents to retain more control than the UGMA and UTMA accounts. Someone who has contributed to a Section 529 account can access the money at any time for any reason. The contributor does not have to worry about explaining it to anyone, and the expense does not have to be for the benefit of the child.

The caution here is that money that is withdrawn from a Section 529 plan that is not used for higher education expenses will be subject to a 10 percent penalty and income tax on the profits. Any underlying investments may also charge you a surrender fee.

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 noncollege purposes, you’d have to pay income tax and a 10 percent penalty on the $5,000 gain.

Coverdell Education Savings Account (ESA) Withdrawal Rules

The noncollege withdrawal rules on the Coverdell ESA fall somewhere between the Section 529 Plan rules and the UGMA/UTMA rules. The money invested is considered a gift to the child, but it can be rolled over to another beneficiary if the first doesn’t have qualifying education expenses by age 30.

Better yet, you do not have to use this account only for college costs. While you can’t use it for food or clothing, as 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 might 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. 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 purposes, the portion of the distribution that represents a gain is taxed to the beneficiary (child) as income and is also subject to an additional 10 percent penalty.