An Overview of Custodial Accounts & The 529 Plan

Custodial Accounts

Let's talk about saving for your child via custodial accounts and the 529b plan. It’s no secret that college is expensive. Parents have noticed and are making saving a priority. Sallie Mae’s annual study “How America Saves for College” found that 60% of parents are saving college funds for children. They’re saving more than prior years and feeling confident that they’ll reach their savings goals.

However, the study also found that many parents don’t have a plan for their savings. 36% of parents don’t have a plan or save money at all. However, planners on the other hand save double what non-planners save ($22,169 and $9,208, respectively).

If your child’s education fund is low (or non-existent), there are a couple of ways to get started, including simply moving some money into your savings account. But there are other ways to accomplish the task and get even better results.

As a mom to twins, one of my financial goals is to support my kids when they go to college. To achieve that goal, I have put a couple of things in place to support this plan. They include splitting up the college savings for each of my children between custodial brokerage accounts and 529b plans. In this article, I'm going to provide you with an overview of both account types.

What is a custodial account?

A custodial account is fairly easy to figure out. It's simply an investment account that an adult controls for minors under the age of 18 (in some states, 21). In my custodial accounts, I can invest funds in the stock market for the financial goals I have set. Saving for my children's college education is one of them.

There are a few very important factors to keep in mind with custodial accounts and they include the following:

Important factors to consider with a custodial account

When it comes to custodial accounts, there are some really important considerations to keep in mind:

When you transfer money into custodial accounts, the money is no longer yours

Any money transferred into a custodial account now belongs to your child, and you are essentially the custodial manager. This means legally; you can only use the funds in this account for expenditures that benefit your child, not yourself.

Once your child reaches age 18 or age 21, they are no longer a minor and will gain full control of the account

The specific age of 18 or 21 where your child is no longer a minor depends on the state you live in. That said, it's important to start teaching your children financial responsibility as early as possible. Things like budgeting their money, staying out of credit card debt, and balancing work and school are key lessons you can teach your child for their financial success!

Your child might need to pay taxes on any income the account makes

In addition, they may need to file a separate federal tax return if that income exceeds $1,000. That is unless it's income from interest, dividends, or capital gains, which you can include in your own tax returns. (It's best to clarify this with a qualified tax accountant)

You may be required to pay gift taxes

If you put more than $14,000 a year into a child's custodial account, you may be required to pay gift taxes.

The money does not have to be used for college

Another big advantage of the custodial brokerage account is that this money could be used for anything since it’s not directly tied to your child’s education. This also means that it isn’t limited to just tuition and fees like college savings plans. But do keep in mind that this could also impact financial aid eligibility for your child.

The next type of account I have for my children is 529b savings, and this is slightly more complicated.

What is a 529b college savings account?

With a 529b plan, you can set aside funds towards your child's future college expenses, i.e., tuition, books, and other educational expenses. These funds can only be used at accredited 2 or 4-year colleges, vocational and technical schools, or at eligible foreign colleges. Unlike custodial accounts, there are contribution limits with the 529 plans. Contribution limits are typically between $300,000 and $500,000 depending on the state.

529b's are typically set up by the state, but you can open a 529b in a state different from your primary residence. Some states offer special tax deductions if you open a 529b in the state where you live. That being said, you want to make sure you are aware of all restrictions on the account, including where your child can attend college. You also want to be aware of the fees and expenses you will be paying compared to the tax deduction you will get.

For example, I chose the New Hampshire 529b plan, although I live in New Jersey. At the time of writing this, my state does not offer any sort of tax deduction or incentive around the 529b. However, under the New Hampshire plan, my kids can go to college anywhere in the country.

About 30% of parents are saving for college using 529 plans. These plans are sponsored by a state or state agency and provide tax-advantaged savings. Almost every state has at least one plan, and you can even opt into an out-of-state one if you’d like. (More on all that below.)

Types of 529b plans

There are two types of 529 plans:

Prepaid tuition plan

This works similarly to a credit system. You essentially prepay future tuition and fees at today’s costs. Your funds are limited to the stipulations set by the plan you have (e.g., covers tuition for only a specific university). These are becoming less common.

Education savings plan

This is an investment account for future college expenses and can be used for tuition, fees, room, and board.

Benefits of the 529b

The main benefit of having a 529b in place for your child is the tax benefit. Once you begin making contributions, your earnings can grow tax-deferred. If the money is used for qualified education expenses (which is the purpose of the 529b), then those distributions will not be taxed by the federal government.

Taking money out of a 529b

You may take money out of a 529b at any time for any reason. However, if the money is not used towards your child's college education expenses, then it is subject to income tax as well as a 10% federal tax penalty.

How a 529b invests your money

Since the 529b is a state-sponsored program, your money is typically invested on your behalf by established brokerage firms. You can open your 529b account in various funds and pick what plan works best with your objectives for your child's college savings.

One of the most popular approaches is selecting funds based on the age of your child. This approach starts out investing more aggressively, but as your child approaches college age, the investment mix gets more conservative, i.e., more money in cash and bonds vs. funds. Alternatively, you can create your own investment mix from the brokerage firm's available portfolios in their 529b plans.

Remember with a 529b plan that the money still belongs to you whereas with a custodial account the funds belong to the child. To take a deeper look into 529b, visit the IRS website here.

Save for your child's future with a custodial account or 529 plan

As college expenses continue to rise, it’s important to take steps today with a child's savings plan to help your child get an education without worrying about burdensome student loan debt. If you are a new mom planning for your baby’s future, it’s not too early to start. And if you’re years behind, don’t worry; it’s never too late either.

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