It’s no secret that getting an education isn’t cheap, and costs continue to rise. College costs have risen an average of 3% per year over the last 10 years for tuition and fees alone at a four-year public college.
In honor of 529 Day, celebrated on May 29th each year, we’re looking at two ways to save for college—529 plans and custodial accounts. Which one is right for your beneficiary’s goals? Here’s some information for you to compare and contrast.
The 529 plan, named after a section of the Internal Revenue Code, offers two distinct ways of saving. You can choose a prepaid tuition plan, or, you can open a qualified tuition plan that allows you to invest contributions and make withdrawals for qualified educational expenses later. Most states offer one or more 529 plans, so you can choose the one that best meets your needs.
Check out NerdWallet’s comprehensive listing of state 529 plans to explore your options!
Anyone can open or contribute to a 529 plan, though states impose certain contribution limits. And, while contributions are made with after-tax money, many states do offer account owners a tax break on those funds. For example, the money in a 529 plan grows tax free, and you can withdraw those funds free of taxes too—provided you use the money for qualified educational expenses. Otherwise, you’ll be forced to pay taxes on distributions and a 10% penalty on earnings.
You could encounter this scenario if some or all of your 529 plan funds go unused, such as if your child or beneficiary doesn’t go to college or chooses a less expensive school than you anticipated. You do have the option to move unused funds over to another beneficiary (including yourself) for educational costs.
Of course, it’s always best to consult an investment and/or tax professional before committing funds to a college savings program.
One benefit of opening a custodial account is its flexibility, it can be used for expenses other than saving for college. While a 529 plan limits the use of funds to qualified educational costs, there’s no such requirement for custodial account holdings. Depending on your family’s situation, the benefit of having flexibility to use the funds for purposes other than educational costs may be worth considering in the event the child chooses a different direction for their future.
So, what is a custodial account? Custodial accounts include the Uniform Gifts to Minors Act (UGMA) accounts and Uniform Transfers to Minors Act (UTMA) accounts. The custodian, any adult as defined by your respective state’s law, opens the account in the name of a minor and makes contributions of any amount.
Unlike 529 plans, contributions to an UGMA or UTMA account are not tax-deductible and earnings in a custodial account are subject to taxation. Moreover, contributors to UGMAs and UTMAs do not receive tax credits or deductions as may be the case with contributors to 529 plans.
Keep in mind that custodial accounts are held in the name of the minor and not the custodian, which has a few important effects:
Both custodial accounts and 529 plans can help build a financially stable future for a child. While a custodial account can be used for any type of financial benefit to the child, a 529 plan is exclusively for the child’s education payments. Take a look at the graph below for more insight:
|Custodial Account||529 Plan: Prepaid Tuition Plan||529 Plan: Investment Plan|
|Other Names||UGMA and UTMA account||Qualified tuition program||Qualified tuition program (that is not pre-paid)|
|Accounts Offered By||LendingClub, brokerage firms, banks, and other financial institutions||States (most often) |
Note: Most state prepaid tuition plans require either you or your child to be a resident of the state offering the plan when you apply
|States, state agencies, and educational institutions Note: You’re not required to use your own state’s plan, though your state may offer incentives for doing so|
|Who Can Open the Account||Any adult, as defined by state law, depending on your state||Anyone at least 18 years old||Anyone at least 18 years old|
|Account Structure||Varies per financial institution||Contributions are generally used to purchase credits at participating colleges at today’s costs||Contributions are invested in one or more investments offered through the plan|
|Contribution Limit||No limit||Lifetime contribution limits vary by state (generally $235,000 to $520,000)||Lifetime contribution limits vary by state (generally $235,000 to $520,000)|
|Income Limit for People Who Own or Contribute to Account/Plan||None||None||None|
|Tax Deductions or Credits||None||Federal: No |
State: Yes, most states offer tax advantages
|Federal: No |
State: Yes, most states offer tax advantages
|Tax-Free Earnings||None||Federal: Yes |
State: Yes, in most states
|Federal: Yes |
State: Yes, in most states
|Tax-Free Withdrawals||None||Yes, if distributions are used for qualified educational costs, federal taxes and most state taxes are avoided||Yes, if distributions are used for qualified educational costs, federal taxes and most state taxes are avoided|
|Power Over Assets Belongs To||Named custodian while child is still a minor The child when they reach adulthood||Account owner (typically a parent on behalf of a minor beneficiary)||Account owner (typically a parent on behalf of a minor beneficiary)|
|Assets May Be Used For||The benefit of the minor only||Cost of tuition and fees at participating colleges (typically state schools)||Cost of tuition, fees, books, supplies, room and board at any college, and certain other educational expenses like elementary and secondary school tuition|
|Ability to Change Beneficiary of Account||No||Yes, you may make yourself the beneficiary or change the beneficiary to a qualifying immediate family member||Yes, you may make yourself the beneficiary or change the beneficiary to a qualifying immediate family member|
|Penalty for Using Account Assets for Non-Educational Purposes||None||Yes, 10% federal tax penalty on earnings unless you qualify for a penalty waiver||Yes, 10% federal tax penalty on earnings unless you qualify for a penalty waiver|
|Assets Considered on the FAFSA||Assets belong to the beneficiary and factor in to the EFC more than parents’ assets do||Assets belong to the account owner (usually parents) and impact the EFC less than the child’s assets do||Assets belong to the account owner (usually parents) and impact the EFC less than the child’s assets do|
Choosing a custodial account or 529 plan for future education costs depends on your personal financial situation and that of the beneficiary.
Simply identify which features matter most to you and talk with a financial or tax professional to discuss how your choice will affect your finances. Either way, congratulate yourself on taking steps now to save money later for a bigger return on your investment in education!
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