Custodial account vs 529: What’s the right choice for your loved one’s future?

Many people want to set up their loved ones for success but don’t know how to do it. Parents, grandparents, uncles, aunts, and family friends all want to help the children they love grow and succeed.

One way that people can put a child on the path toward financial success is to give them a financial gift. Many people opt to invest money in a 529 account, a special tax-advantaged account designed to help people save for college.

Others choose to establish custodial accounts, which enable the child to use the money in whatever way they wish, once they reach the age of majority. 

But, which account is right for your loved one? 

Both can be useful, in different situations. We’ll break down the pros and cons of each, so you can be confident you’re investing your hard-earned money in the best way to help your young loved ones as they grow.

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What is a Custodial Account?

A custodial account is a type of financial account that someone, (the custodian) manages on behalf of a younger person. 

Most frequently, people use custodial accounts to give money to minors without giving them full control over the funds. The custodian retains the power to manage the account until the minor comes of legal age, but the minor technically owns the funds deposited into it.

Two of the most popular types of custodial accounts are Uniform Transfers to Minors Acts (UTMA) accounts and Uniform Gifts to Minors Acts (UGMA) accounts. 

The accounts are very similar. The primary differences are that UGMAs can only hold financial assets, like cash, stocks, and bonds, but they’re available in all states. 

While an UTMA account can hold more types of assets (such as real estate and vehicles), some states haven’t adopted the law that lets people establish them.

Benefits of custodial accounts

There are several benefits to opening a custodial account for your children, nieces, nephews, grandchildren, or other people you care about.

One is that custodial accounts let you make financial gifts without giving the child full control over the money. 

When you give money to someone, they can do whatever they want with it, even if they’re a child. You might not want to give a child hundreds or thousands of dollars, only to see them waste it on toys or other things. By giving through a custodial account you can give them the money while letting a custodian manage the funds. The custodian can invest the money and help it grow.

The child will only gain access to the account once they become an adult. That gives them time to mature and make sound decisions about how to use your gift.

Because money given to someone through a custodial account becomes that person’s property immediately, there can be tax benefits for the giver. In 2023, you can give up to $17,000 to a person, tax-free. Gifts over that limit will count against your lifetime gift tax limit of $12.92 million.

If you make annual gifts of $17,000 or less, you can give money without it counting against your gift tax limit. (Married couples filing jointly can gift up to $34,000 per recipient in 2023.)

Early giving can also be more impactful. 

The longer money stays invested in the market, the more time it has to grow. You can also use a custodial brokerage account as an educational opportunity, showing the child how it is being invested and how it grows over time. This can help them learn important lessons about finance, such as how mutual funds work or how to use a brokerage account.

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Custodial accounts are also highly flexible. Once the recipient comes of age, they can use the money for any purpose.

That means the money in the account can go toward whatever their heart desires, whether it’s a college education, a gap year in Europe, funding a startup business, a down payment on a house, or paying for a wedding.

Drawbacks of custodial accounts

Custodial accounts aren’t perfect, so it’s important to keep the drawbacks in mind.

One is that there may be better alternatives if the recipient plans to go to college. Custodial accounts are flexible and can be used for anything, but other accounts, like 529s, offer tax benefits if you use the money in them to pay for college.

Student assets also play a role in colleges’ decisions about financial aid. If a student has a big nest egg in a custodial account, colleges might offer fewer grants and other forms of need-based financial aid.

Another drawback is what’s colloquially known as the “kiddie tax.” This tax is designed to prevent wealthy people from giving money to their children to dodge taxes. The law governing the kiddie tax underwent changes in 2020.

For 2022, a child’s unearned income up to $1,150 is not taxed. Income between $1,150 and $2,300 is taxed at the standard rate for single people. Any unearned income over $2,300 is taxed at the parent’s marginal tax rate. (For 2023, the thresholds are $1,250 and $2,500.)

Parents should consult with tax professionals to consider their options and the best way to navigate taxes based on their financial situation.

Traditional custodial accounts also make it difficult for multiple people to contribute. 

Typically, you’d need to give money to the custodian and ask them to add it to the account. EarlyBird fixes this problem, making it easy for multiple people to contribute to the same UGMA.

What is a 529?

A 529 is a special type of investment account that is designed to help people save for college savings. 

Typically, they’re used to help parents, family, and friends, save money to send a child to college, though they can be used for other education purposes.

529s place restrictions on the money in the account, but offer tax benefits in exchange.

Benefits of a 529

It’s no secret that college is expensive and that its cost is only rising. 62% of college graduates in 2019 had student loan debt with the average balance totaling $47,671.

It’s understandable that parents want to help their child pay for college by setting money aside.

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529s were designed to help parents do that and to help each dollar go a bit further when it comes time to pay for the cost of schooling.

The primary advantage of 529s is that they offer tax incentives for saving. However, those incentives can get complicated. Each state has a different 529 plan and different incentives.

Federally, you pay taxes as normal when contributing money to a 529. However, money in the account can grow tax free and any funds you withdraw will not be taxed. That means that you don’t have to worry about capital gains taxes or other taxes when you take money out of the account to pay for school.

Many states add additional benefits. For example, Massachusetts lets people deduct up to $1,000 contributed to a 529 from their income when filing their state taxes. Depending on your state’s rules and income tax rate, the savings could be significant.

Drawbacks of a 529

One major drawback of 529s is their complexity. 

There are fifty states and each state has its own rules and tax benefits for contributing to a 529. Whether putting money in a 529 is a good idea could vary heavily with where you live. 

People in high-tax states that offer deductions give a lot of incentives for contributing. People in states with no income tax or contribution incentives have much less reason to contribute.

The most significant drawback of 529s is that they heavily restrict how money in the account can be used. Money in a 529 can only go toward qualified educational expenses, such as:

• Tuition
• Room and board
• Books
• Student loan payments
  

Other costs that may be related to education, but that don’t qualify, aren’t eligible. Some common examples of non-qualified expenses include:

• Room and board off campus (above the cost of on campus room and board)
• Groceries
• Transportation to and from school
• Application and testing fees
  

It can be hard to know precisely which expenses qualify and the penalties for using money in a 529 on non-qualified expenses can be steep. You’ll have to pay federal income tax on whatever amount is used for non-qualified expenses. On top of that, you have to pay a 10% penalty on the money used for those expenses.

This applies even if the student finishes school and has money left in the 529. Those funds are locked in the account behind the taxes and penalties.

What are Custodial 529s?

Custodial accounts include any type of account that you open for a child and have a custodian manager. It is possible to combine 529s and custodial accounts, opening a custodial 529 for a child.

Doing this gives the child more control over the money when they become an adult. They’ll have the freedom to spend the money as they wish, even if that means making non-qualified purchases and paying the tax penalties.

However, custodial 529s usually aren’t a great idea. 

The person establishing a 529 can usually change the beneficiary of the account, which is useful if a student gets a scholarship and doesn’t need all the money in the account.

With custodial 529s, the named student is the account owner, so only they can change the beneficiary.

Custodial 529s also give up the primary benefit of custodial accounts: giving the child flexibility to use the money for any purpose, by designating it solely for education expenses.

Is a Custodial Account or a 529 Account Right for Your Loved One?

It’s difficult to know whether a custodial account or a 529 account is right for your loved one. 

There are pros and cons to each and which is best will depend on many factors, including your income, the child’s goals, and where you live.

The first thing to consider is whether the child in question is planning on going to college. If someone has no intention of pursuing higher education, opening a 529 for their benefit is a bad idea. The restrictions placed on the funds will significantly reduce the gift’s value.

If someone is very young and you’re not sure whether they’ll go to college, it may be best to hold off on contributing to a 529 until you know more about their personality, strengths, and goals.

If you know for certain that the child you want to give a gift to is planning to go to college, then a 529 might be worth considering. Still, you have to weigh the pros and cons of the account.

Putting money in a 529 poses a significant opportunity cost. 

There is a short list of things that you can pay for using the funds in a 529. Some things, like buying food, even if you’re in school, aren’t included. For these restrictions to be worth dealing with, the benefit has to be significant.

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If you live in a state that has high taxes and lets you deduct some of the money you contribute from your state taxes, such as Massachusetts or New York, that can give you more of a reason to put money in a 529 over a custodial account.

In general, it’s likely better to give money to people using custodial accounts because it’s a gift that comes with no restrictions or strings attached. 

The heavy restrictions of a 529 are only worth dealing with if the tax benefits are very high and you’re certain that the recipient will use the money for education.

Conclusion

There isn’t a single answer as to whether custodial accounts or 529s are better. 

In general, custodial accounts tend to be far more flexible and are best if you’re not completely certain that the child will attend college. 

529s become more compelling if you know that the child will need help paying for college, but the money in a custodial account can still be used for educational expenses. 

529s do have tax benefits, but the precise benefits vary by state, so if your state doesn’t give significant tax breaks, the benefits might not be worth the additional restrictions.
Want to start a custodial account for your loved one? Download the EarlyBird app and start investing in their future today.

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