In a nutshell, 529 plans and Education Savings Accounts (ESAs), also known as Coverdells, offer tax-deferred growth and tax-free withdrawals for qualified expenses. Custodial accounts, also known as UGMAs or UTMAs (named after the Uniform Gifts to Minors Act and Uniform Transfers to Minors Act), feature fewer restrictions and limited tax benefits.
Withdrawals are tax-free for qualified college and graduate school expenses. There are no annual contribution limits—just a lifetime limit of about $300,000 or more per beneficiary for all states. Also, bear in mind that you can fund a 529 plan in any state without limiting your child’s choice of college and gift taxes may apply.
Additionally, 529 savings have a minimal impact on federal financial aid because they are assessed at a much lower rate than the child’s assets. If a grandparent or other relative has a 529 account with your child as the beneficiary, those distribution payments will be counted as student income and could have a significant impact on financial aid decisions.
Cashing out will count as a non-qualified withdrawal, and the earnings portion (meaning growth from dividends and price appreciation) will be subject to federal and state income tax, plus a 10% penalty. If your child gets a scholarship, you can request a penalty-free withdrawal—but even if that's granted, you may still be taxed on earnings.
A custodial account is a brokerage account that you set up and manage on behalf of a child. It’s turned over to them when they reach the age of majority (21 in most states).
Advantages: The sky’s the limit in terms of contributions, and there are no restrictions on your investment options. Gift taxes may apply.
Drawbacks: This gift is irrevocable, and once your child reaches the age of majority, he or she can spend the money on college—or anything else; you no longer control the funds. Also, income from the accounts may be subject to “kiddie tax” rules where investment income above $2,100 is subject to be taxed at the parents’ rate.
Contributions to these three types of accounts count as gifts, for which you can claim the yearly $14,000 ($28,000 for couples) exclusion per child. If you want to invest more generously in a 529 plan, you can contribute what amounts to five years of the exclusion in a single year ($70,000 for single parents; $140,000 for couples) per beneficiary. You just can’t make any additional gifts in those five years.
It’s possible to fund more than one type of college account. But you may find it’s simplest to keep one tax-advantaged plan for educational costs, and a custodial account (or even a regular brokerage account) for other expenses that wouldn’t qualify for tax-free distributions—like a car—anyway. IRS publication 970 can help outline the tax implications of your choice.