Thanks to its tax benefits, a 529 savings plan is a popular choice for families setting aside money for educational costs. If you’re looking for more flexibility in how the money can be used, though, a custodial account may be the better choice.   

Key takeaways:

• A 529 savings plan is a tax-advantaged investment account that can help families pay for educational expenses. But there are limits on how you can use the money.
• Custodial accounts offer beneficiaries greater spending discretion, but there are fewer tax breaks.
• Recent changes put in place by the SECURE Act and SECURE 2.0—including the option to roll some assets into a Roth IRA—have made 529s more flexible than they used to be.

Setting up a college savings account for the children you care about can be a wonderful gift. It can help them graduate with little or no student debt and give them a great head-start in life.

But where, exactly, should you invest that money to be sure you’re getting the most bang for your buck?

Two of the most popular choices are 529 plans, which were designed specifically to help families save for college, and custodial accounts, which can be used for educational expenses but also for other purposes.

What Is a 529 Plan?

529 plans are state-run tax-advantaged savings accounts that allow you to set aside money for a child’s future educational expenses.

There are two main types of 529 plans:

• With a 529 prepaid tuition plan, you can lock in the current tuition rate and avoid any potential increases.
• With a 529 education savings plan, you can use an investment portfolio to grow money for your child tax-deferred.

Both plans set limits on how withdrawals can be used if they are to remain tax-free, but the 529 education savings plan generally offers families more benefits than a prepaid tuition plan. It’s also the more commonly used option, so we’ll focus on the education savings plan here.

How to Use a 529 Education Savings Plan

529 savings plans can vary from state to state, so you’ll want to be sure you know how your state’s program works before signing up. But typically, these plans offer the opportunity to invest in mutual funds, exchange-traded funds (ETFs) and/or target-date funds.

When you make a withdrawal from a 529 plan, you’ll have to disclose whether you’re using the funds for qualified educational expenses (such as tuition, room and board, and textbooks) or unqualified expenses. If your withdrawal is for an unqualified expense, you’ll incur a 10% penalty and you’ll have to report those funds as income on your state and federal taxes.

You can use a 529 savings plan from any state to pay for an eligible school in your state or any other. Keep in mind, though, that you may only receive a break on your state income taxes if you use the plan in the state where you reside.

Pros and Cons of a 529 Savings Plan

Because they were specifically created to incentivize families to save for college, there are several upsides to choosing a 529 savings plan. And recent changes put in place by the SECURE Act and SECURE 2.0 made 529s more flexible. But it’s important to be aware of the potential pitfalls as well.

Pros

• Tax Benefits: The money in a 529 plan can grow tax-free, and qualified withdrawals won’t be subject to federal or state income taxes. Many states also offer state tax credits or deductions for 529 contributions.
• High Contribution Limits: Though aggregate or lifetime contribution limits can vary by state, there are no yearly contribution limits.
• Newly Added Flexibility: Thanks to changes put in place by the SECURE Act, tax-free withdrawals can now be used to pay for registered apprenticeship programs and up to $10,000 in certain student loan repayments. And, starting this year, as part of the SECURE 2.0 Act, you can roll unused assets—up to a lifetime limit of $35,000—into a Roth IRA for the beneficiary without generating any taxable income or triggering the 10% penalty for nonqualified withdrawals.

Cons

• Investment Limits: You likely won’t have the same range of investment choices as you would with some other accounts.
• Managing Leftover Funds: The options for using leftover funds have increased, but there are still strings attached.
• Impact on Financial Aid Eligibility: The plan could potentially reduce the amount of financial aid a beneficiary can receive.

What Is a Custodial Account?

Another popular way to save money for education expenses is to use a custodial account through either the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA). These accounts allow families to give a significant financial gift to a child with the understanding that the account will become that child’s property when he or she reaches adulthood.

This means that although a custodial account may be established with the intent of funding a child’s education, the beneficiary doesn’t have to use it for that purpose: Unlike a 529 plan, there are no penalties or governmental hoops to jump through if the beneficiary doesn’t want or need the money for school.

How to Use a Custodial Account

The major difference between UGMA and UTMA accounts is in the type of assets that can be used to fund them:

• With a UGMA, you can use only financial assets, such as cash, stocks, and mutual funds, to fund the account.
• With a UTMA, you can also put tangible assets, such as cars, jewelry, real estate, etc., into the account.

When you open a custodial account, you can transfer any amount of assets into it, and you and others can continue making contributions over time with some tax advantages. Any individual can put up to $18,000 annually in a custodial account without reporting the gift to the IRS. In this way, a custodial account can serve as a  less expensive alternative to setting up a trust.

However, as the account custodian, you will likely have to pay taxes on the investment earnings. A portion (up to $1,250 in 2024) of any earnings from the custodial account may be exempt from federal income tax, and a portion (up to $1,250 in 2024) of any earnings in excess of the exempt amount may be taxed at the child’s tax rate. But any earnings over that amount will be taxed at your rate.

Pros and Cons of Custodial Accounts

One of the best things about a custodial account is that once the account transfers to your beneficiary, the funds can go toward anything he or she wants. Of course, this could also be a problem if your loved one decides to use the account’s assets on something frivolous. Here are a few other pros and cons to consider:

Pros

• More Investment Options: UGMA and UTMA accounts can hold a wide array of assets. And you’ll continue to have a say over how assets are managed until the account transfers to your beneficiary.
• No Contribution Limits: Unlike 529 plans, custodial accounts have no aggregate contribution limits. You can give as much as you like.

Cons

• Tax Limitations: Custodial accounts have some tax advantages (and no penalties), but 529 plans offer more tax savings overall.
• Gifts Are Irrevocable: There are no takebacks—even if you need the money or want other children to share in the account assets.
• Impact on Financial Aid: Because a custodial account is considered the child’s asset, there may be a negative impact when applying for financial aid.

Which Plan Is Right for You?

Picking the plan that’s best for your family may come down to weighing the tax advantages of the 529 plan against the flexibility of a custodial account. You’ll also want to keep your risk tolerance in mind, as well as your short- and long-term goals.

At JJ Burns & Company, we understand the importance of getting this gift right—for you and the child you love. And we know that the sooner you can get started saving, the better. Don’t hesitate to connect with us today so we can help.

529 plan custodial accounts