Should You Save for Your Children’s Future Using a Custodial Account or a 529 Plan?

Written by Banks Editorial Team
3 min. read
Written by Banks Editorial Team
3 min. read

Custodial accounts and 529 plans are commonly used to save for college. There are have similarities between a custodial account vs. a 529 plan, but there are also differences to be mindful of when researching your options. Keep reading to learn more about how they work, the key differences between the two, how to decide which is best.

What is a Custodial Account?

A custodial account is a taxable investment account you can open for your child to start saving for their future. You act as a custodian when opening the account. It remains in your control until your child reaches legal adulthood, as determined by the state. 

Choose from one of the following: 

  • Uniform Gift to Minors Act (UGMA) account: can be used to hold cash, annuities and securities
  • Uniform Transfers to Minors Act (UTMA) account: can be comprised of any type of asset

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What is a 529?

A 529 plan is designed to help you save for the costs of college. It’s sponsored by the state and permits post-tax contributions of up to $30,000 (married couples) or $15,000 (singles). You’ll have to pay gift tax on contributions that exceed this amount. Any earnings on contributions are tax-deferred, and withdrawals are not subject to taxation if used for qualifying education expenses. 

There are two types of 529 plans: 

  • Prepaid tuition plan: allows you to save for tuition and lock in today’s rate for the future
  • Education savings plan: lets you save money for an assortment of college expenses

If you choose a prepaid tuition plan, it can only be used in your state of residence. 

The Differences Between a Custodial Account vs. a 529 Plan

Below are the key differences between a custodial account vs. a 529 plan

  • Annual contribution limits: Both allow annual contributions of up to $30,000 (or $15,000 per parent), respectively, without being assessed gift taxes. However, 529 plans also have a lump-sum contribution option. You can make a one-time contribution of $150,000 (or $75,000 per parent) to cover five years of contributions without being subject to gift taxes. 
  • Total contribution limit: There are no overall contributions limits for custodial accounts. However, 529 plan contributions are limited to the amount your child needs to cover education expenses. This figure is determined by the state. 
  • Ownership: Custodial accounts belong to the child but are supervised by the parent until the child reaches the age of majority. 529 plans are the parent’s property and remain under their control until transferred to the beneficiary to cover education costs. If funds remain after expenses are paid, or the child decides not to attend college, the balance can be transferred to a sibling. 
  • Tax consequences: Any earnings on assets in custodial accounts are subject to kiddie tax. However, 529 gains are not assessed federal income tax if used for allowable college expenses. 

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Advantages and Disadvantages of Custodial Accounts vs. 529 Plans to Save for Your Children’s Future

Before deciding which option is best to save for college, consider the benefits and drawbacks of a custodial account vs. a 529 plan.

Pros and Cons of Custodial Accounts to Save for Your Kids

Benefits: 

  • Generous annual contribution limits (that are not subject to gift tax) 
  • No overall contribution limit 
  • More flexible than many other investment tools used to save for college

Drawbacks: 

  • Gains are subject to kiddie tax 
  • No particular tax advantages for using the funds to cover education costs
  • Could impact financial aid eligibility 

Pros and Cons of 529 Saving Plans to Save for Your Kids

Benefits: 

  • Generous annual contribution limits (that are not subject to gift tax) 
  • Tax-deferred growth and tax-free withdrawals if funds are used for qualifying expenses
  • Transferable to relatives if the funds are not used by the beneficiary

Drawbacks: 

  • Total contributions are limited to the amount needed for educational expenses 
  • Subject to federal income tax and a 10 percent penalty if for non-qualifying expenses
  • Costs of room and board are not allowable expenses under prepaid tuition plans 

Should You Open a Custodial Account or a 529 Plan to Save for Your Child’s Future?

It depends on your goals and financial situation. The assets in custodial accounts belong to the child, and there are no restrictions on how funds can be used. So, if the child decides not to go to college, penalties and federal income tax will not be assessed when funds are withdrawn. But unlike 529 plans, these accounts do not receive the same preferential tax treatment. 

A 529 plan is more tailored towards college savings and offers considerable tax benefits. However, they aren’t as flexible, and you could be hit with penalties and federal income tax to withdraw the funds if the child decides college isn’t a good fit and you don’t have a relative to transfer the funds to. 

Before moving forward with a custodial account or 529 plan, carefully weigh the benefits and drawbacks of each to make an informed decision. 

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