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Custodial Account vs. 529 Plan: Which Is Better?


Parents have the opportunity to build funds for their child’s education through savings vehicles like a 529 plan or a custodial account. Both of these options allow adults to store away money that could one day support their child’s future. But which one is right for you? It all depends on what you want out of your savings tool, including tax advantages, contribution limits and flexible beneficiary transfer. With that in mind, here is the information you need to know when choosing between a custodial account and a 529 plan.

A financial advisor can offer valuable advice on how to ensure that your family has the money it needs to cover educational expenses.

Custodial Account vs. 529 Plan: Accounts

Starting with custodial accounts, parents or guardians can open these on behalf of a minor. They’re, essentially, taxable trusts where you store assets until the child reaches a certain age. Once they reach the “age of majority,” usually around 18 to 21, they can access the account. That includes any returns made from the investment and the original principal.

Custodial accounts come in two forms: Uniform Gift to Minors Act (UGMA) accounts and Uniform Transfers to Minors Act (UTMA) accounts. UTMA accounts hold almost any type of property, including real estate, whereas UGMA accounts are limited to financial products. That includes assets such as cash, annuities and securities.

Then, you have the alternative savings vehicle known as a 529 plan. Along with the District of Columbia, every state sponsors at least one 529 plan, or a “qualified tuition plan.” And, like custodial accounts, there are two types: prepaid tuition plans and general savings plans.

A savings plan is the simpler version. Parents can put money in it and eventually use the funds for qualified college expenses, i.e., tuition, room and board and mandatory fees. In comparison, the prepaid tuition option lets the adult buy units or credits from participating institutions for future tuition at today’s prices. However, these plans don’t usually cover room and board.

Custodial Account vs. 529 Plan: Taxes

Boy and his piggy bank

If you are looking for tax advantages, you probably want to consider a 529 plan. Using funds from a custodial account on education does not come with tax benefits. However, the IRS considers the minor the owner. That comes with a perk. Children under the age of 19 (or 24 for full-time students) who file keep the first $1,100 of yearly unearned income tax-free. After that, the next $1,100 gets taxed at the minor’s tax rate. Any unearned income above the $2,200 limit is taxed at the parents’ rates.

In contrast, 529 plans come with tax benefits on their withdrawals. Similar to a Roth IRA, the account’s investments grow tax-fee. In addition, you can take out funds without facing taxes as long as you use the money for qualified expenses. Like this, undergraduates and graduates can offset all qualified education costs. Although, expenses at the K – 12 level have an annual tax-free withdrawal limit of $10,000. After that, they (and non-qualifying expenses) face income tax and a 10% penalty.

Custodial Account vs. 529 Plan: Contributions

Technically, parents won’t face an annual limit when they contribute to a 529 plan or a minor’s custodial account. However, they have to deal with gift tax limits. According to the IRS, the 2021 limit is $15,000 per parent and $30,000 per married couple.

It’s also possible for parents to front-load their child’s 529 plan and, thus, get around the gift tax limit. Essentially, the IRS allows you to contribute up to five years’ worth of the annual gift tax exclusion with no consequence. So, instead of paying $15,000 for your child per year, you put in $75,000 immediately. Contributing with your spouse allows you to put in a total of $150,000.

These larger contributions avoid gift taxes and allow you to take advantage of compound interest. But adults should pay attention to the state limits set on their plan, beforehand.

Comparatively, custodial accounts don’t face any contribution limitations outside the lifetime gift tax exclusion ($11.7 million per individual or $23.4 million per couple).

Custodial Account vs. 529 Plan: Ownership

College graduation day

The funds in a 529 plan never transfer ownership from a parent to a beneficiary. This is actually a benefit to the account holder. It provides extra flexibility for them if the child chooses a different path or only uses some of the money. For example, a couple’s first-born child may go to college. However, the child doesn’t use all the funds in the 529 account. In that case, the parents can use the rest of the money for a younger sibling’s education. You can change beneficiaries without any negative income tax consequences as long as the next beneficiary is still family.

In contrast, you don’t have the same flexibility with an UGMA or UTMA account. They’re considered irrevocable gifts where the adult invests on behalf of the minor. So, they’re simply supervising for the child who will take ownership once they hit adulthood. As a result, you can’t change the beneficiary. Because these funds are part of the minor’s estate, they may also impact financial aid eligibility more than a 529 plan does.

But, once the UGMA or UTMA account is in the child’s hands, they have more control over spending than they would with a 529 plan. Therefore, the custodial accounts represent more flexibility for the child since they can use the funds to benefit them in other ways.

Custodial Account vs. 529 Plan: Which One Is Right for You?

In the end, custodial accounts and 529 plans each have their pros and cons. It’s up to each family to decide the right option for them. Factors such as current financial situation, goals for the child and more can all affect how parents make their decision. It also depends on the compromises they’re willing to accept. For example, guardians may want to take advantage of the 529 plan’s tax benefits.

However, 529 plans come with more limitations on use. You can’t repurpose the funds there for something else. You can only transfer them to another relative if your child doesn’t go to college. Otherwise, you face heavy financial penalties.

In contrast, custodial accounts lack tax advantages but allow more flexibility. The child isn’t restricted in their use. They can put the money towards things outside of school that are still important.

Bottom Line

Custodial accounts and 529 plans are great tools for families to get ahead on saving for college. A custodial option like an UTMA or UGMA account provides some more flexibility when it comes to spending funds. However, it lacks some of the tax advantages. In contrast, 529 plans allow you to take advantage of tax-free withdrawals but lead to strict penalties if you don’t use the money for a qualified expense or beneficiary.

Tips on Savings

  • Consider working with a financial advisor as you seek the best way to prepare for college. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • Savings accounts are a great tool for education expenses. But if you want to get the most of your investment and build wealth, you need one with a higher yield. You can compare your interest rate on a high yield savings account with college savings vehicles like a 529 plan or custodial account to find the right option for you. The greater the interest, the more money you can earn in the long run.
  • Don’t stop shopping for the right saving option before you find the right one. Other choices out there, like CDs and money markets, may help you toward your financial goals. Regardless of which avenue you choose, remember to check in with a savings calculator. That way, you can monitor your progress and plan for your future.

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