For many parents, worries about financing higher education for their children start the moment their babies are born. Since paying for college is a daunting expense, it is no wonder many families want to start saving as early as possible. The question, though, is which is the best way to save for college?
There are currently two primary options. The first is a custodial account, while the second is a 529 plan.
Here is a detailed look at these options to help in making an informed decision.
529 Plans in Depth
Two basic kinds of 529 plans exist – prepaid tuition and general savings plans. The savings plan enables money to be put aside for college expenses. Meanwhile, the prepaid plan allows parents to pay for their child’s tuition in the future at the today’s current rates. All states offer 529 plans, with some offering both varieties, while others provide just one.
What Should I Know about Custodial Accounts?
Custodial accounts are taxable investment accounts opened on a child’s behalf. Two types exist: UGMA accounts (Uniform Gift to Minors Act) and UTMA accounts (Uniform Transfers to Minors Act).
A UGMA account is limited to cash, annuities, securities, and other similar assets, while UTMA accounts can hold virtually all kinds of assets. For both, the custodian establishes the account for the minor. The custodian then controls it until the minor has reached legal adulthood.
There are different rules in different states regarding legal adulthood age and the way they name custodians. Apart from this, the accounts work like all other investment accounts.
Who Owns the Funds?
With 529 plans, the funds stay in the parent’s estate. Ownership will never transfer to the account beneficiary, enabling parents to transfer ownership as required. For example, one child may not need the entire fund for college. Therefore, the parents can transfer the rest to younger siblings. The parents will keep control of all funds, whatever age their child may be.
Custodial accounts, meanwhile, are the child’s asset with supervision by their parents. When a child reaches maturity, the account funds become his or her property legally. Even before a child reaches that age, the funding remains within the child’s estate rather than the parent’s. As a result, custodial accounts have more of an impact on eligibility for financial aid.
Account Contributions
There is no technical limit to how much parents can contribute to either plan every year. However, a gift over a specific threshold could have consequences in terms of lifetime gift tax.
For 529 plans, parents can make lump-sum gifts covering five years of contributions without any gift tax consequences. This option is not available for custodial accounts.
There is an overall contribution limit for 529 plans, with each state setting its own limit. However, there is no such limit for custodial accounts.
Neither type of account has a contribution limit based on the parent’s income. This means high-earning parents can still use these vehicles for saving.
Taxation
The 529 plan has a tax-beneficial option for saving for college. The federal government does not offer any tax benefits if you contribute to your child’s 529 plan. However, some states may provide relief. When it comes to withdrawals, though, the tax treatment is very favorable. Parents can withdraw funds from a 529 plan for qualified education expenses, such as books, rooms, and tuition, and the distributions including earnings, are tax-free. This applies at both the graduate and undergraduate levels. Parents can also use as much as $10,000 annually to offset qualified expenses from the K through 12 levels.
Should parents withdraw funds from 529 plans for non-educational purposes, the earnings can be taxed at the ordinary income tax rate. Also, there will be penalties assessed at 10 percent. Some states even require payback of tax benefits received when the contributions were made.
Generally there are no tax benefits when using funds for educational purposes with custodial accounts. The income earned in the custodial accounts can be subject to the “kiddie tax” which the income is taxed at the parents’ effective tax rate.
The Advantages and Disadvantages
Both plans offer their benefits.
A 529 plan offers significant tax benefits. However, parents can only use the funds for very restricted purposes. Custodial accounts have no such usage restrictions and, therefore, are more flexible. However, they lack tax benefits. Custodial account funds are also the child’s property, therefore, the child can use them however they wish once they reach adulthood.
If you need more information to help make the right choice or advice about individual tax preparation, we can help you make informed choices about financing higher education for your child.
For questions or more information about this article, please contact our tax professionals at taxalerts@windes.com or toll free at 844.4WINDES (844.494.6337).