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Saving for College: What's the Difference Between a 529 Plan and Custodial Account?

By Carrie Schwab-Pomerantz
Key Points
  • Getting a head start on college saving is smart but how you save is also important because of taxes and financial aid eligibility.

  • 529 plans and custodial accounts are two common college savings vehicles but they have some significant differences.

  • Whichever you choose, don't sacrifice your own retirement for a child's education.

Dear Carrie,

As a relatively new parent, I’m confused about the best way to save for my son’s college. He’s only 3 years old, but I want to get started now. What would you suggest?

—A Reader

 

Dear Reader,

First, let me say you’re smart to start thinking about saving while your son is still so young. As parents, we have a lot of financial obligations, and paying for college is one of the toughest of all. According to the College Board's College Cost Calculator, a child born this year may need more than $222,000 to attend a four-year, in-state public university, based on current published tuition, fees, room and board and assuming inflation increases of 5 percent; private schools may cost almost twice that much. You may not have to pay nearly that much, but there’s just no getting around it: College is expensive.

Fortunately for their kids, according to the 2018 Sallie Mae report, How America Saves for College, parents are rising to the challenge. Nearly two-thirds with children under 18 are saving for college. Interestingly, parents with kids age 0-6 are equally likely to be saving as those with older kids.

Up, up and away

Clearly, starting early and contributing as much as possible are both important. But how you save is also important for a number of reasons, including the impact on taxes and financial aid eligibility. Let’s take a look at the two most common college savings vehicles.

529 plans

I’m a big fan of these state-sponsored education savings accounts, which have four main benefits:

1. Tax advantages: Although you contribute to the account with after-tax money, your investment grows income tax-deferred and you don’t pay federal taxes (or penalties) on withdrawals so long as they’re used for qualified college expenses such as books, room and board, and tuition. Many states offer residents a full or partial tax credit or deduction for contributions to their state’s plan—and some states allow you to deduct contributions to any plan.

2. Improved financial-aid eligibility: A 529 is generally considered a parental asset. That’s important because only 5.64 percent of parental assets are factored in when calculating your Expected Family Contribution (EFC)—the number that determines a child's eligibility for need-based federal student aid—while typically 20 percent of the child’s assets may be considered.

3. High contribution limits: 529 plans permit significant contributions, with many allowing $400,000 or more over an account’s lifetime. (Contributions vary by state and plan type.) And based on the fact that in 2019 you can gift an unlimited number of individuals $15,000 a year ($30,000 per couple) without being subject to gift taxes, a 529 account allows you to accelerate a gift tax-free lump sum contribution of up to $75,000 ($150,000 per couple) by electing to treat the gift as though it were spread evenly over five tax years.

4. Flexibility: If your son receives a full scholarship or decides not to attend college, you can change the beneficiary to another qualifying family member, such as a sibling, stepsibling or even yourself. Also, in addition to paying for higher education, recent tax reform allows you to use up to $10,000 per year from a 529 for tuition at private or religious K-12 schools. (You may be subject to state taxes and penalties on the earnings portion—check with your state’s tax laws.) On top of that, anyone can contribute, so a 529 offers a great opportunity for grandparents or others to help out.

Custodial brokerage accounts

A custodial account is another option. This is an investment account in your son’s name that you set up and manage on his behalf until he reaches adulthood. One advantage is that it has fewer restrictions than a 529 plan. For example, you can make withdrawals at any time without penalty, as long as the money benefits the beneficiary (your son), and there are no lifetime limits on contributions. The tax advantages, however, are few.

As with a 529, in 2019 you can contribute up to $15,000 ($30,000 per couple) to a custodial account without incurring the gift tax. Income-tax wise, you’re exempt from taxes on the first $1,100 of earnings per year. The next $1,100 to $2,200 is taxed at the child’s rate (often 10 percent—the lowest income tax bracket). Anything over $2,200 is subject to be taxed at a potentially much higher rate.

More important, a custodial account is an irrevocable gift, which means the money becomes your child’s property once he reaches your state’s “age of majority” (usually 18 or 21). So, it’s a bit of a risk: Your son may spend the money on college, as intended, or he could choose something completely different.

There's also a potential financial aid disadvantage. Because the accounts are considered a student asset, they’ll be factored into the EFC at the higher rate of 20 percent.

Don’t neglect retirement

As natural as it is to want to put your kids first, I firmly believe that before saving anything for your child’s college, you should fund your retirement accounts (at a minimum, contribute enough to capture the maximum employer match, and much more if you can). So I was heartened to see in the recent Sallie Mae report that the percentage of parents planning to use retirement funds to pay for college has gone down from 20 percent in 2016 to 10 percent in 2018. That's definitely something I applaud for two reasons.

First, if you withdraw funds from a 401(k) before age 59½, you’ll pay a 10 percent penalty in addition to income taxes. Worse, you might jeopardize your own financial future by depleting your current funds and potential future earnings. So, as important as college is, our retirement should always come first. Think of it as another way of taking care of our children by ensuring we’re financially independent once we’re no longer working.

In any case, I encourage you to carefully review all your options, keeping in mind what’s best for you and your son. And congratulations again for thinking about this now. By starting to save for your son’s education early, you’re giving him a gift that will last a lifetime.
 

Have a personal finance question? Email us at askcarrie@schwab.com. Carrie cannot respond to questions directly, but your topic may be considered for a future article. For Schwab account questions and general inquiries, contact Schwab.

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Investors should consider, before investing, whether the investor’s or designated beneficiary’s home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available in such state’s qualified tuition program.

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The information provided here is for general informational purposes only and is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, consult with a qualified tax advisor, CPA, financial planner or investment manager. 

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