Congratulations on the new addition to your family! Planning for your child’s financial future is a significant step, and two popular options to consider are 529 plans and custodial accounts. Below, we break down the key benefits and drawbacks of each option to help you make the best decision for your growing family.
529 Plan
Tax Advantages:
- Contributions to a 529 plan grow tax-deferred, and withdrawals are tax-free when used for qualified education expenses. This means you won’t be taxed on the earnings as long as they are used for educational purposes.
High Contribution Limits:
- 529 plans generally allow for high contribution limits, enabling significant funds to accumulate over time.
Control Over Funds:
- The account owner retains control over the funds and can change the beneficiary to another qualifying family member if the original beneficiary does not need the funds for education.
Cons:
Limited Use:
- Funds must be used for qualified education expenses to avoid taxes and a 10% penalty on the earnings.
Investment Options:
- Choices are typically limited to the investment options offered by the plan.
Custodial Account (UTMA/UGMA)
Flexibility:
- Funds can be used for any purpose that benefits the child, not just education. This includes expenses like buying a car, travel, or starting a business.
Broad Investment Options:
- You can invest in a wide range of financial products, allowing potentially greater growth depending on market performance.
Cons:
Taxation:
- Earnings are subject to the kiddie tax, meaning they may be taxed at the parent’s higher tax rate.
Control:
- The child gains full control of the funds at the age of majority (18 or 21, depending on the state), which means they can use the money as they see fit.
Common Questions Answered
What happens if there’s surplus money in a 529 account and it’s used for non-qualified expenses?
If funds from a 529 plan are used for non-qualified expenses, the earnings portion of the withdrawal is subject to income tax and a 10% penalty. To avoid this, consider splitting contributions between a 529 plan for education-specific savings and a custodial account for more flexible use.
Can surplus funds in a 529 plan be used for another child’s education?
Yes, one of the key benefits of a 529 plan is its flexibility in changing the beneficiary. You can change the beneficiary to another qualifying family member, including siblings, without incurring penalties.
Contributions from Grandparents:
Gift Tax Considerations:
- Contributions from grandparents are subject to annual gift tax exclusion limits ($17,000 per beneficiary for 2023).
- Grandparents can also contribute up to five years’ worth of gifts in one year ($85,000 per beneficiary) without triggering gift taxes by making a special election on their tax return.
How to Decide Between a 529 Plan and a Custodial Account
Ultimately, the best choice depends on your financial goals and your child’s future needs. Here are some scenarios to consider:
- Primarily Saving for Education: A 529 plan’s tax advantages make it an excellent choice for education-focused savings.
- Flexible Savings for Various Needs: If you’re looking to save for multiple future expenses beyond education, a custodial account might be more appropriate.
Final Thoughts
Both 529 plans and custodial accounts offer distinct advantages, and many families choose to use a combination of both to balance tax benefits and flexibility.