Custodial Account vs. 529 Plan: Which One is Better?

Almost every parent wants to help cover their children’s education expenses. While putting a little away for college savings is a goal, deciding where to put the money can be somewhat confusing.

Should the money go into a custodial account vs. 529 plan? What plan lets a parent control the money, and what tax benefits are available?

If you are in this situation or planning on having children, the following is a “must-read” so that you know what options you have.

What is a Custodial Account?

A custodial account is a bank account that allows a parent to put away and manage money on behalf of a legal minor. A parent can control the money until the child reaches the age of majority, even though the minor technically owns the funds.

There are two popular types of custodial accounts: Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA) accounts.

• UGMA: A UGMA account can only comprise financial assets such as cash, stocks or bonds and is available in all states.
• UTMA: A UTMA account can hold all of the above but also contain other assets such as real estate, vehicles and artwork. Such accounts are not universally accepted across all U.S. states, and tax benefits vary.

No matter which type of account you open or what company’s product you use, custodial accounts are an irrevocable gift that you are required to turn over to the child once they become “of age.”

Fidelity and Charles Schwab manage two popular custodial account products.

Benefits of Custodial Accounts

There are several benefits to a custodial account:

• Transfer of assets to a child: A parent can support a child’s future by giving the account owner a certain amount of savings, be it investment money, funds for a house, college education, or just for living.
• Flexibility: There are no limits on how the child spends the funds in a custodial account.
• Earnings taxed at child’s tax rate: With either type of account, the first $1,150 is federal tax free, and the second amount of $1,150 is taxed at the child’s rate (which does not apply to contributions exceeding $2,300).
• No contribution limits: There are no limits on how much a parent or guardian can put into either type of account, although gift tax can apply in certain circumstances.
• No withdrawal penalties: Once the child is an adult, there are no withdrawal penalties. A custodial account is a lot less expensive than a trust fund and has much fewer rules and tax applications.
• Efficiency: A custodial account is a bank account but with certain management criteria.
• Estate planning: A custodial account is a way to control how much money your kids get beyond estate planning.

Drawbacks of Custodial Accounts

There are some drawbacks to a custodial account:

• Lack of tax breaks: Apart from the first $2,300, there are no tax breaks with custodial accounts.
• Irrevocable: Once you make the gift, it belongs to the child, and you cannot change the beneficiary.
• Reduction in financial aid eligibility for the child: Assets in the account are considered income for your child.
• Reduction of government aid: Having an account could negatively impact your child’s government aid (student loan).
• No tax shelter: The IRS views the first $1,150 as tax free, whereas the second $1,150 is taxed at the child’s rate. Married couples can give individually.
• Control of the funds: With custodial accounts, once your child is an adult, they control the funds.

What is a 529 Plan?

A 529 plan is an investment product that lets a parent save money for college expenses. You can use the funds for direct educational expenses (qualified expenses); in exchange, the account comes with tax benefits.

Major players in this type of investment include Fidelity and Vanguard.

Benefits of 529 Plans

The following are the benefits of a 529 plan:

• No annual contribution limits: There are no limits on how much a person can contribute.
• Flexible plan location: You can open a 529 plan anywhere.
• Easy to open and maintain: Like custodial accounts, a 529 plan is simple to open and maintain.
• No age limit for contributions or distributions: Anyone can contribute to the plan and withdraw the money for qualified expenses.
• Tax-deferred growth: You will owe no federal income tax for educational costs.
• Tax-free withdrawals: Qualified withdrawals are not counted as income, and there is no tax penalty for withdrawals.
• Tax-deductible contributions: Contributions are tax deductible.

Drawbacks of 529 Plans

There are a few drawbacks to the 529 plan to consider:

• Cannot lock in tuition costs: While the plan counts as saving for college, the cost of tuition is fluid. The bottom line is that you can still be responsible for the difference if tuition fees rise.
• Charges fees: 529 plans have a fee structure.
• Limited investment options: Growing the plan depends on the brokerage you use.
• Different fee levels per state: Each state has different limits and rules regarding 529 plans and state taxes.
• Must use funds for education: 529 plans must go to direct educational expenses (which are pre-approved from a list).
• Restriction on switching investments: Moving the investment is difficult.

529 vs. Custodial Account: How do they compare?

Both types of accounts can ensure your child has funds for the future. Before making any investment decisions, consider the similarities. Neither type of investment account has contribution limits or withdrawal penalties.

The differences in the two types of accounts break down like this:

529 Plans	Custodial Accounts
Tax-deferred growth	Transfer assets to a child
Flexible plan location	Earnings taxed at child’s tax rate
Must be used for education	Reduction of government aid
Cannot lock in tuition costs	No tax shelter

Which is Better: Custodial Account or a 529?

Deciding which type is best for you depends on your own specific circumstances and requirements.

Choose a Custodial Account If:

• You want your child to have spending flexibility.
• You want a fund with no withdrawal penalties.
• You want to set assets aside for a child but not the cost of a trust fund.

Choose a 529 Plan If:

• You know your child will go to college.
• You want to make sure that any funds go to educational costs.
• Growth is tax deferred.

FAQs

The following are frequently asked questions about both accounts.