by Landon Buzzerd, CFP®
August 22, 2024
When it comes to savings strategies for your children, understanding the savings vehicles available will help you make the best decision for your child’s future. Two common choices are 529 education savings plans and custodial accounts. Both options have their own set of advantages and considerations, and choosing the right one depends on your goals and circumstances.
Both 529 plans and custodial accounts are easy to open and offer valuable benefits, but they serve different purposes. The decision for which account is most appropriate should be guided by your financial goals and preferences. A 529 plan is ideal if you want to save specifically for educational expenses while benefiting from tax-free growth and withdrawals. The 529 offers structure and tax advantages but with limitations on investment choices and flexibility. Conversely, a custodial account provides broader investment options and flexible use of funds but lacks the same tax benefits and can lead to potential loss of control once the beneficiary comes of age. Whether you are already a parent or are planning for a future family, this is a great time of the year to revisit existing savings plans or to create a brand new one.
Comparison Chart Between 529 Plans and Custodial Accounts
529 Education Savings Plan
The most common vehicle for education savings is the 529 Education Savings Plan. A 529 plan is a tax-advantaged savings account specifically designed for educational expenses. Nearly every state offers a 529 plan, and most do not require investors to be a resident to open an account. Certain benefits and plan features may vary by plan, but we will be discussing the universal features that are unique to 529 plans.
Most 529 plans have low minimum contribution limits, which makes them accessible to families across different income levels. Contributions are limited to the annual gifting exclusion amount which tends to increase every few years. Currently, contributions to a 529 plan can be up to $18,000 per child per individual, with married couples able to contribute a combined $36,000 annually per child. This amount may be deductible for state income tax purposes, though not for federal taxes. Additionally, you can make a lump-sum contribution of up to $90,000 per beneficiary (or $180,000 for married couples) by leveraging five years’ worth of the annual gift tax exclusion in one year. This large contribution can avoid gift taxes but comes with the stipulation that this exclusion cannot be used again for the same beneficiary until the five-year period elapses. Should the donor pass away within this period, a portion of the gift might revert to the estate and be subject to taxes.
One of the primary advantages of 529 plans is their tax treatment. Funds in these accounts grow free from both federal and state income taxes, and withdrawals used for qualified higher education expenses (such as tuition, room and board, and textbooks) are exempt from federal income tax, with many states offering similar exemptions. Additionally, the account owner retains control over the assets, regardless of the beneficiary's age. The owner can also change the beneficiary to another family member if needed. For example, an older child has funds remaining in their 529 after completing their education. Moreover, assets in 529 plans are protected from bankruptcy and are not included in the owner’s estate, which can be advantageous for estate planning.
As a result of SECURE ACT 2.0, a new feature of a 529 incorporates retirement funding as well. In the event 529 funds are not needed for the beneficiary’s education due to receiving a scholarship, a decision not to pursue higher education, or just greater than expected investment performance, the excess funds may be used to fund a Roth IRA for the beneficiary. Under certain conditions, you can roll over tax and penalty-free up to a lifetime limit of $35,000 in a 529 to a Roth IRA. The 529 account must have been opened for more than 15 years and the contributions are still subject to annual Roth IRA contribution limits ($7,000 for 2024 for account holders under age 50).
However, 529 plans do have their drawbacks. Investment choices are generally restricted to a set range of options, and the plan usually allows changes to investments only twice per year. Furthermore, if funds are withdrawn for non-educational purposes, they may be subject to taxes and penalties, which can be a drawback if you need more flexibility.
Custodial Accounts
If you would like to begin saving and investing on behalf of a minor but do not want the funds to be limited to educational purposes, a custodial account may be a viable solution. These accounts fall under the Uniform Transfers to Minors Act (UTMA) or Uniform Gifts to Minors Act (UGMA) and provide a different set of features for managing assets for a minor. Custodial accounts are controlled by a custodian, usually a parent, who manages the assets on behalf of the minor. While the custodian oversees the account, the assets are considered owned by the minor and must be used for their benefit.
Unlike a 529 plan, there are no contribution limits on a custodial account. Contributions may be made with cash or existing shares of stocks, mutual funds, or other securities aside from cash. Custodial accounts offer broader investment choices and greater flexibility in how the funds can be used. There are also no restrictions on how the funds from the account are used, just that they are used for the benefit of the minor. Although these accounts do not have a contribution limit, they do not offer the same tax advantages as 529 plans. Any income the account earns above a threshold ($2,500 for 2024) is taxed at the custodian's rate, which could be a consideration for future tax planning.
A significant disadvantage of custodial accounts is the loss of control once the beneficiary reaches the age of majority, which can range from 18 to 26 depending on the state. At this point, the beneficiary gains full control over the account and can use the funds however they wish, which may not align with the custodian’s original intentions. If greater control over the use and distribution of assets is desired beyond the age of majority, establishing a trust might be a more appropriate option.
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