Recently, we’ve been fielding a lot of questions from clients asking us which is better investment account for a child: a 529 plan or a custodial account? First, let’s understand the premise of each one. A 529 plan is a tax-advantaged investment account meant to help pay for educational expenses. A custodial account is a regular investment account held in a minor’s name, that is controlled by an adult (the custodian) until either age 18 or 21. Both of these accounts have different pros and cons, that may make them more appealing than the other.
Comparing a 529 plan with a custodial account
The table below shows the similarities and differences between a 529 plan and custodial account:
Let’s discuss the similarities first. Both investment accounts are set up for the benefit of a minor. Technically, someone other than a parent can set up and fund the account, such as a grandparent for their grandchild. The IRS doesn’t stipulate a contribution limit for either account on the federal level, but states do impose contributions limits for 529 plans themselves (which vary by state). Note that contributions to either account will count towards your annual gift tax exclusion. However, the gift tax exclusion is something that affects the ultra wealthy much more than the the average household (article coming on this soon!).
So which one is better?
There isn’t a clear winner when determining which account is better. They each have their own pros and cons. The biggest determining factor in which one will be best depends on what is more important to you: tax advantages or flexibility? Also, where you live can have a big impact on your decision since some states have more favorable tax treatment of 529 plans than others. For example, if you live in Illinois, you can deduct up to $10,000 ($20,000 per couple) in contributions to a 529 plan. (Remember, there is never a federal deduction for contributing to a 529 plan, only a potential state deduction).
If you live in California, which is a very high tax state, you’ll be disappointed to find out that you are not allowed to deduct your 529 plan contributions. This may limit the appeal of the account to California residents. Click here for a full list of states that do or do not allow 529 plan deductions.
Beyond the deduction criteria, another major tax advantage of the 529 plan is that earnings grow tax-free inside the account. The key is that the earnings, when withdrawn, must be used to pay for qualifying education expenses. If you make a non-qualified withdrawal, the money will be subject to taxes and penalty. Click here for a list of qualifying education expenses.
On the other hand, any money in a custodial account can be withdrawn at any time and used to pay for just about anything, provided it benefits the account holder. However, earnings in the custodial account will be subject to the Kiddie Tax.
More on withdrawals & the “kiddie tax”
Often times we see these accounts contrasted in black and white. Like the fact that the 529 plan allows for gains to grow tax-free and the custodial plan does not. However, the reality is a bit more nuanced due to rules like the kiddie-tax. The kiddie-tax states that the first $1,100 in gains in a minor’s account is tax-free. And the next $1,100 is taxed at the child’s tax rate. Therefore, if your child has no income, they can essentially take $2,200 in profits per year totally tax-free from a custodial account. This is important because it means that as long as you’re dealing with small figures, the custodial account can realistically mimic the same tax-free characteristics that a 529 plan can.
Ultimately, in our experience, the number one reason parents opt for the custodial plan is the built in flexibility. Funds can be withdrawn at any time provided they are used for the benefit of the child. Some common uses of funds from a custodial account that aren’t eligible from a 529 plan include:
- medical bills
- starting a business
- high-level athletic training (sports camps, travel teams, etc)
- gap year/mission trips
- musical instruments/lessons
Perhaps the biggest caveat is that if the minor does not end up attending college, 529 plans risk going to waste for that individual. The funds can be rolled over to another 529 plan for a different beneficiary (like a sibling) but they cannot be moved into an IRA account, for instance.
The bottom line
If you are very confident that your child will go to college then a 529 plan makes a lot of sense due to the tax-free growth of the account and possible state tax deductions. However, if you’re unsure about your child’s future college plans, then the flexibility provided by a custodial account may be a better option. To be sure, there is nothing stopping you from opening both accounts. Additionally, you can always start with a custodial account and roll that money into a 529 plan later on. But you can’t do the opposite: start with a 529 plan and move that money into a custodial account later. Please contact us to learn more about the differences between these accounts and help you determine if you should open one (or both) for your child or grandchild!