Custodial Account vs. 529 Plan

Parents and guardians have two main ways of investing for their children’s future: 529 accounts and custodial brokerage accounts. While both allow you to invest funds on behalf of your kids, that’s about where the similarities end.

Here’s what you need to know about the differences between custodial brokerage accounts and 529 plans.

How do 529 plans work?

The primary benefit of 529 accounts is that they often offer tax advantages when used for your child’s educational expenses. Most 529 accounts are run by states, government agencies or schools and come in two primary forms: prepaid tuition plans and college savings plans.

Prepaid tuition plans essentially allow you to prepay your kid’s future tuition at today’s prices. They are primarily intended for in-state families whose children will be attending a state college or university. Only nine states currently offer these plans to new enrollees. Most require that you, or your child, be a resident of that state. They allow you to buy credits or prepay tuition for eligible in-state public colleges and universities (though will provide a proportional payment for a private or out-of-state university if your child opts to go there instead). Money may not be eligible for room and board expenses and may not go as far if your child chooses not to attend a participating institution, according to the SEC.

College savings plans, on the other hand, allow you to invest money for any higher institution in any state. In fact, you can invest money for any kind of educational expenses your child may incur. While people traditionally associate that with college and university costs, they can also be used to fund trade school and even to finance private, public or religious elementary, middle and high-school tuitions. 

Because money is invested, 529 funds have the opportunity to benefit from the wealth-generating potential of the stock market. This means you may be able to contribute less of your money to reach your college savings goals. It does introduce a level of risk, though. Investments in the stock market may lose value, even when held in 529 plans. But historically, the market has recovered from every downturn and continued to grow.

Are there tax benefits to a 529 plan?

When used for educational expenses, 529 accounts function a lot like Roth Individual Retirement Accounts (IRAs). As a parent or guardian, you’re able to contribute money into a 529 for your child and any investments grow tax-free. As long as your child uses those funds for educational expenses, they’ll never have to pay any taxes on them.

In addition to tax-free growth, certain states may also let parents deduct contributions from their taxes.

A word of warning: 529 funds used for non-educational expenses may be subject to income taxes and a 10 percent penalty.

How do custodial brokerage accounts work?

Unlike 529 plans, custodial brokerage accounts are generally offered by financial companies, such as investment brokerages, and come with comparatively few limitations. Before your child turns 18 or 21, depending on your state of residence, you can use funds for any purpose that benefits your child, like clothes for school.

Once your child reaches your state’s age of majority, they can use the money in their custodial brokerage account for any purpose of their choosing—without penalty. This means funds held in a custodial brokerage account offer more flexibility than those held in 529 accounts.

What’s the benefit of a custodial brokerage account?

529 plans generally offer a relatively limited range of investment options, like target-date funds (a mutual fund created to automatically shift your portfolio mix as you age) or pre-designed portfolio mixes based on risk level. Custodial brokerage accounts function much like your own, allowing for comparatively broader offerings, like exchange-traded funds (ETFs), mutual funds, individual stocks or predesigned options like you’d find in 529 plans.

Are there tax benefits to a custodial brokerage account?

Unlike 529 accounts, custodial brokerage accounts don’t explicitly come with any tax advantages. Any realized growth (when you withdraw funds from the account) or dividends may be subject to income taxes.

Because these accounts are legally your child’s, though, they may offer some tax benefits.

The first $1,100 of dividend income may be tax-exempt annually. And the next $1,100 is often taxed at the child’s tax bracket (generally 10 or 12 percent). Once gains reach about $2,200, however, the minor child’s investment income will be taxed using brackets and rates for trusts and estates—which may potentially be higher than the parents’ tax rates. This is referred to as the Kiddie Tax. 

Who can contribute to a custodial brokerage account or 529 plan?

Parents and guardians aren’t the only people who can invest for their children’s future. Friends and family members can both contribute to custodial brokerage accounts and 529 accounts.

Are there gift-tax contribution limits for either account?

Because custodial brokerage accounts and 529 accounts are both considered by the IRS as gifts to your child, they’re both subject to gift tax if any one person’s contributions exceed $15,000 a year.

For example, you and your mother can each contribute $15,000 a year to your child’s 529 or custodial brokerage account without incurring a gift tax. With 529 plans, you may be able to gift up to $75,000 without incurring a gift tax, provided you opt to spread that contribution over five years and don’t make any additional contributions during that time.

Married couples can jointly contribute $30,000 without incurring gift taxes, meaning parents can gift $30,000 to a child annually. Those with multiple children can gift $15,000 ($30,000 if married) to each child before incurring a gift tax. (Gift taxes are generally paid by the gifter, rather than the recipient.)

Does either account have a lifetime contribution maximum?

Though they’re very high, 529 accounts may have lifetime maximums. Each state allows for contributions of up to $325,000. Depending on the state you have your plan through, your contribution maximum may be higher.

Custodial brokerage accounts, on the other hand, have no annual or lifetime contribution limits. Gifts exceeding $15,000 annually may incur gift taxes, though.

Can a beneficiary be changed on either plan?

Even though there is one named beneficiary on a 529 account, the account holder can change this to another family member, like a sibling or even one of the parents themselves. That way, contributions won’t go to waste or become inaccessible should a child choose not to use all of the 529 funds. Custodial brokerage accounts, conversely, become the designated child’s irrevocably and cannot be used even by a parent in any way except to benefit the child directly.

Is financial aid affected by a custodial brokerage account? 

Because any assets held in a custodial brokerage account are legally your child’s, they weigh more heavily in the Free Application for Federal Student Aid (or FAFSA) calculations. Funds held in 529 accounts are considered less heavily.

Whichever account you choose—a 529 plan or custodial brokerage account—each offers an opportunity to get a jump-start on saving for the high costs of college. And that’s a decision you won’t regret.