You want the best for your child’s future, and that may mean helping them set a firm financial foundation with savings and investments. There are countless ways you can invest on behalf of a child, each with its own advantages. Both custodial accounts and 529 plans are excellent options for unique situations.
Should you choose a custodial account vs. 529 plan for your family? Learn more about which type of account might be best for you here!
What is a Custodial Account?
Parents who are unsure what their child may require money for in the future should investigate whether a custodial account is the best path forward. This is a savings account or an investment account for a minor that allows you to invest on behalf of a child until they come of age. They will not be able to access funds within the account without the consent of the custodian (the adult).
Why might you choose a custodial account over other investment vehicles?
The main reason why parents tend to pursue this investment vehicle is because it is extremely flexible. You can contribute without limit, no matter your income level. Children do not have to take regular distributions and funds can be withdrawn for anything that benefits them rather than strictly educational expenses.
There are also tax advantages to a custodial account. Namely, the earnings of the account should be taxed at the child’s rate when included on a parent’s tax return. No taxes are levied on the first $2,600 of unearned income. Plus, you can contribute up to $18,000 in 2024 with no federal gift tax incurred. If you are married, you can double that amount.
However, it’s important to note that a custodial account belongs to the child which factors into what they could be eligible to receive for financial aid when enrolling in college. Deposits made are irrevocable, meaning you cannot change your mind at a later date and take the money back.
The beneficiary is also set in stone, not allowing you to transfer money to another child with more expensive tuition, for example.
What is a 529 Plan?
While a custodial account can be used for any purpose that may benefit a minor child, 529 plans are uniquely designed to help with the cost of education. They feature an education savings plan as well as prepaid tuition plans with tax-deferred growth and tax-free withdrawals when used for education expenses.
They can even lock in tuition rates at today’s prices (at eligible schools), even for future enrollment. With tuition costs on the rise, this can be a savvy move for parents to offset costs for tuition at any level including K-12 expenses.
What are the pros and cons of choosing a 529 plan for your child’s future?
First, withdrawals are always exempt from federal and state income taxes when used for your child’s education. Most other withdrawals will incur a 10 percent penalty, ensuring that your child will want to use the funds for education or lose out on some of the benefits. Some states even allow an income tax deduction for contributions into that state’s plan.
In addition, the SECURE Act 2.0 allows 529 accounts to roll over to a Roth IRA (up to $35,000) for accounts that are at least fifteen years old. This means that if the child doesn’t attend university or there are extra funds left in the account, nothing gets wasted.
Unlike a custodial account that allows you to contribute without limit, you are held to the gift tax exclusions (up to $18,000 in 2024). You can also contribute a lump sum contribution of up to five years of annual gift tax exclusions without penalty. If you are late to start saving for educational expenses, this can be a great way to bolster an account quickly while reducing your taxable estate.
Of course, not everything is excellent for 529 plans. There are fewer investment options and the specific fees you face depend on your state. Not to mention, you may be faced with restrictions if you decide to try to change plans at some point in the future.
Custodial Account vs 529: Which is Best?
If you have to decide between a custodial account vs. 529 plan, which one is best?
The two accounts are quite different. Custodial accounts are general investment accounts that allow you to buy and sell securities on behalf of a child. 529 plans are specific to education and are usually sponsored by individual states, giving you fewer investment options.
In the past, the 529 plan used to have the drawback of only permitting a minor to use the funds for an educational expense, so custodial accounts tended to be more popular. With this drawback gone under the new SECURE 2.0, a 529 plan is more desirable than it once was. Your investment can still be put to good use even if it’s not used for education by rolling it into a Roth IRA.
A 529 plan also has more tax benefits like tax-deferred growth and tax-exempt withdrawals on a qualifying education expense. Custodial accounts will have more taxes on dividends and will not be tax-exempt for any purpose.
Plan for the Future with Magellan
Magellan can help you create a comprehensive plan with estate, financial, legal, and tax planning all under one roof. If you have been thinking about investing for the future, allow us to walk you through the benefits of a charitable remainder trust, custodial account, or 529 plan to give your family future financial stability. Contact us today to learn more.
For a comprehensive review of your personal situation, always consult with a tax or legal advisor. Neither Cetera Advisor Networks LLC nor any of its representatives may give legal or tax advice.
This material provided by Kevin Meaders was written by Axle Eight, a non-affiliate of Magellan Planning Group and Cetera Advisor Networks LLC.
All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful.
Investors should consider the investment objectives, risks, charges and expenses associated with municipal fund securities before investing. This information is found in the issuer's official statement and should be read carefully before investing.
Investors should also consider whether the investor’s or beneficiary’s home state offers any state tax or other benefits available only from that state’s 529 Plan. Any state-based benefit should be one of many appropriately weighted factors in making an investment decision. The investor should consult their financial or tax advisor before investment in any state's 529 Plan.