Compare The Key Differences Between UGMAs vs Coverdell ESAs

Saving for a child’s education is a priority for many families, but understanding which education savings plan fits best can be overwhelming. Two options often compared are UGMA custodial accounts and Coverdell Education Savings Accounts. Both offer unique benefits, but they also come with different rules and limitations. If you're evaluating UGMA vs Coverdell ESA, this article explores how each works and what to consider.

Understanding the Basics

What Is a UGMA Account?

A UGMA (Uniform Gifts to Minors Act) account is a custodial account set up by an adult to hold and protect assets for a minor until they reach the age of majority. These accounts allow for the transfer of assets such as cash, stocks, or mutual funds as irrevocable gifts to a child. The child gains full control over the account, once they reach the age 18 or 21, depending on the state

UGMA accounts have no contribution limits, and anyone can make gift contributions. However, there are federal income tax implications to consider. The unearned income in the account may be taxed at the child's tax rate, but income in excess of a certain amount may be taxed at the parent's rate due to the "kiddie tax" rules.¹

What Is a Coverdell ESA?

A Coverdell Education Savings Account is a tax-advantaged savings account designed specifically for educational expenses. These plans allow families to make plan contributions for a child's qualified education costs, including both college education and secondary education expenses.

Unlike UGMA accounts, Coverdell ESAs have an annual contribution limit of $2,000 per beneficiary. Contributions must be made before the beneficiary turns 18, unless they are a special needs beneficiary. In addition, there are income limitations for contributors, which means that higher earners may not be eligible to contribute directly.

• For single filers, the phase-out range begins at $95,000 and ends at $110,000.
• For married couples filing jointly, it begins at $190,000 and ends at $220,000.²

Coverdell ESAs offer tax-deferred growth, and withdrawals are typically tax-free when used for qualified education expenses.

Who Might Consider Each Option?

When UGMA May Be a Fit

• Flexibility in Use: Funds aren't restricted to education, making them useful for broader goals.
• No Income Caps: There are no income tax rules limiting who can contribute.
• Unlimited Contributions: Ideal for families wanting to make large gift contributions without a limit per beneficiary.

However, it's important to consider that once the child reaches the age of majority, they can use the funds for any purpose, not just education. Also, the account's assets can affect financial aid eligibility more heavily than other college savings plans.

When a Coverdell ESA May Be a Fit

• Focused on Education: Ideal if the goal is strictly to save for education tuition, expenses from kindergarten through college.
• Tax-Free Growth: Offers tax-free withdrawals for qualified withdrawals, including secondary education expenses and even costs related to current education.
• Qualified Expense Coverage: Covers a wide range of qualified education costs—from books to room and board to technology, depending on the school’s requirements.

However, families must manage around the income limitations and the annual contribution cap. If a child's education expenses exceed the contribution limits, families may need to explore additional contributions through other savings methods.

Pros & Cons of Each Option

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Additional Considerations

• Age Limits: Coverdell ESAs require contributions to stop once the beneficiary reaches age 18 (unless they have special needs), and funds must generally be used by age 30.
• Tax Implications: UGMA accounts may lead to higher taxes if the investment income exceeds certain thresholds. Coverdell ESAs offer federal income tax advantages for qualified withdrawals.
• Impact on Financial Aid: UGMA accounts are considered student-owned assets, under FAFSA. This may potentially reduce aid eligibility by up to 20% of the assets value. Coverdell ESA assets are generally considered parent-owned, assessed at up to 5.64%.³
• Flexibility: UGMA accounts provide more freedom in how the money is eventually used, but Coverdell ESAs offer greater tax efficiency for education savings.

Alternative Education Savings Options

529 College Savings Plans

Designed for education: A 529 plan is a tax-advantaged account used to save for a broad range of qualified education expenses, from K–12 tuition to college and even student loan repayment in some cases.

Tax benefits: Earnings grow tax-deferred, and withdrawals are typically tax-free when used for approved education costs.

Contribution flexibility: These plans generally allow higher contributions than other education-focused accounts.

State incentives: Some states offer tax deductions or credits for residents who contribute to their in-state 529 plan.

Considerations: Withdrawals for non-qualified expenses may be taxed and subject to a penalty on earnings.

Savings Bonds (Series EE and I Bonds)

Education-friendly tax benefits: Interest earned on Series EE and I Bonds may be excluded from federal income tax when used for qualified higher education expenses under specific conditions.

Eligibility requirements: Bonds must be purchased by someone age 24 or older and generally need to be registered in the parent's name if the funds are used for a dependent’s education.

Income limits apply: The tax benefit phases out at certain modified adjusted gross income (MAGI) thresholds, which are updated annually by the IRS.

Low-risk savings option: Though they offer more modest returns than market-based accounts, these bonds are backed by the U.S. government and include inflation protection.

Custodial IRAs

Dual-purpose savings: Although designed for retirement, a custodial IRA can also be used to help cover qualified education expenses.

Tax-advantaged growth: Qualified withdrawals may avoid the early withdrawal penalty, though earnings could still be subject to income tax.

Earned income required: The child must have documented earned income to contribute, such as from a part-time job.

Annual contribution cap: Contributions are limited to the lesser of the child’s earned income or the annual IRS limit.

Final Thoughts

Whether you're drawn to the flexibility of a UGMA or the education-focused benefits of a Coverdell ESA, both options invite thoughtful planning. Having a clear understanding of how these options work could better prepare you to make informed choices for your child's future.

You may want to speak with a qualified financial professional to explore which path aligns best with your education savings plans.

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Sources

1. Fidelity. "What to know about the kiddie tax." https://www.fidelity.com/learning-center/personal-finance/kiddie-tax
2. Internal Revenue Service. "Publication 970 (2024), Tax Benefits for Education." https://www.irs.gov/publications/p970#idm140647357925776
3. Saving for College. "How 6 Different Assets Can Affect Your FAFSA and Financial Aid Eligibility." https://www.savingforcollege.com/article/how-7-different-assets-can-affect-your-financial-aid-eligibility
4. Fabric by Gerber. "UGMA investment accounts for kids." https://meetfabric.com/ugma-investment-account-for-kids?