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529 Plan vs. Custodial Account: Which College Savings Plan is Best for You?

529 vs custodial account

With student loan debt now exceeding one trillion dollars, many families are making a concerted effort to beef up their college savings so their kids aren’t carrying a heavy debt burden when they graduate. But the rising cost of college is making this more and more difficult.

According to the College Board, the 10-year historical rate of increase in college tuition of about 5 percent is more than double the general rate of inflation, which is around 2 percent. And the College Board estimates that the total cost of sending a child who is born this year to college when he or she turns 18 could be more than $222,000. This is the estimated cost for an in-state public university — a private university could cost at least twice this much.

There is some good news on the college savings front. According to How America Saves for College, a report prepared by Sallie Mae, almost two-thirds of families with kids under 18 years old are actively saving money for college. 

Two of the most popular college savings vehicles for these families are Section 529 plans and custodial accounts. However, there is confusion among some parents about the differences between these tools and their advantages and disadvantages. Following is an explanation of each, including their pros and cons.

529 Plans: Tax and Other Advantages

Section 529 plans are sponsored by states. With prepaid tuition plans, you purchase an amount of future tuition at current prices, which are probably much lower than future prices. With investment savings plans, you can attempt to earn market returns on your college savings by investing your money in stocks, bonds, ETFs and mutual funds.

One of the main attractions of 529 plans is their generous tax benefits. While 529 plans are funded with after-tax money, investments grow on a tax-deferred basis and withdrawals are made tax- and penalty-free as long as funds are used to pay for qualified education expenses. These typically include college tuition and fees, textbooks, and room and board. In some states, residents can also fully or partially deduct plan contributions for state income tax purposes.

529 plans also feature high total contribution limits that vary by state. For example, the limit in Missouri is $325,000 while the limit in Kansas is $418,000 and the limit in Georgia is $235,000. 529 plans offer flexibility in case a child decides not to attend college or receives scholarships. The money can be used by another qualifying family member, such as a sibling, or you can even use the money to go back to school yourself.

There may also be financial aid benefits associated with 529 plans. These funds are classified as parental assets, of which only 5.64% are considered when calculating the Expected Family Contribution (EFC) toward college expenses. Conversely, 20% of a child’s assets are considered in the EFC calculation. 

Custodial Accounts: UTMAs and UGMAs

Custodial accounts are often referred to as UTMAs (Uniform Transfers to Minors Act) and UGMAs (Uniform Gifts to Minors Act). While they aren’t designed specifically for college savings, they have proven to be an effective college savings tool for many families.

These accounts are established by parents on behalf of their children — grandparents can also set up UTMAs and UGMAs on behalf of their grandchildren. The only stipulation is that the money must be used for the financial benefit of the child. There are no lifetime contribution limits or penalties for withdrawals that aren’t used for qualified education expenses like there are with 529 plans.

Unlike 529 plans, however, custodial accounts don’t offer tax-deferred growth or tax-free withdrawals. But they do offer another kind of tax benefit: Annual earnings between $1,100 and $2,200 are taxed at the child’s tax rate, which is often as low as 10 percent, instead of your tax rate. (Earnings up to $1,100 are tax-exempt.)

One potential drawback of custodial accounts is that the money becomes the property of your child once he or she reaches the age of majority, which is 18 or 21, depending on your state. So if your kid decides to use the money to buy a fancy new car or splurge on some other luxury item instead of using it for college education, you may not be able to prevent this, at least legally.

Also, funds held in custodial accounts are classified as a student asset, which means they will be factored into the EFC calculation at the higher 20% rate. This could negatively impact your ability to obtain financial aid.

Save Early and Often

Depending on your particular circumstances, either a 529 plan or custodial account could be the best college savings option for you. Regardless of which type of plan you choose, you’re likely to increase your chances of college saving success by opening the plan as soon as possible and making contributions on a regular basis.

Please give us a call if you have more questions about the best college savings plan for your family.

The commentary is limited to the dissemination of general information pertaining to Frontier Wealth Management, LLC’s (“Frontier”) investment advisory services. This information should not be used or construed as an offer to sell, a solicitation of an offer to buy or a recommendation for any security, market sector or investment strategy. There is no guarantee that the information supplied is accurate or complete. Frontier is not responsible for any errors or omissions, and provides no warranties with regards to the results obtained from the use of the information. Nothing in this document is intended to provide any legal, accounting or tax advice and Frontier does not provide such advice. This information is subject to change without notice and should not be construed as a recommendation or investment advice. You should consult an attorney, accountant or tax professional regarding your specific legal or tax situation.