Custodial accounts provide a simple way to gift money to a minor child. They enable the donor to retain control of the account until the beneficiary reaches the age of majority (typically 18 or 21, depending on the state). Depending on the state, custodial accounts include structures such as UTMA (“uniform trust for a minor”) and UGMA (“uniform gift for a minor”) accounts, and they can easily be set up at a bank, broker/dealer or trust company.
Unlike 529 plans, the funds in the UGMA or UTMA account do not have to be used for higher education expenses. UGMA and UTMA accounts do not have any tax advantages as 529 plans do, although contributions can be designed to qualify for gift tax exemptions. The minor child beneficiary of the custodial account will be responsible for paying income taxes on the earnings generated by the custodial account. Keep in mind that income earned by the minor, including in any custodial accounts, will be subjected to the “kiddie tax” and will be taxed at the parents’ tax bracket if it exceeds certain thresholds.
The advantage of custodial accounts is that they are relatively easy and inexpensive to set up. The disadvantage is that there is very little customization available. For example, with both the UGMA and UTMA custodial accounts the beneficiary will have full access to the accounts when reaching the age of majority, and there is no way to prevent or change this. This is in contrast to a trust, which while generally more expensive and cumbersome to set up, can be customized to suit your individual needs.
529 plans are savings vehicles for the purpose of funding higher education expenses. They have numerous tax advantages, including tax deferral and tax free withdrawals. The withdrawals are typically tax free as long as they are used to fund qualified higher education expenses such as tuition, board, fees, books and other expenses at an eligible school. Under certain circumstances, 529 plan contributions are eligible for a tax deduction at the state and local level.
With a 529 plan, the owner sets up an account for the benefit of a child, grandchild, or other family member (the beneficiary). Unlike with custodial accounts, the owner retains control of the 529 plan account, even after the beneficiary reaches the age of majority. The owner also has the ability to change the beneficiary of the account after establishing it. For example, if a parent creates an account for the benefit of one child and that child later decides not to attend college, the beneficiary of the account can be changed to another child.
Keep in mind that 529 plan contributions are considered gifts and are thus subject to the gift tax rules. For 2016, the gift tax exclusion is $14K per beneficiary. Keep in mind that all gifts, not just 529 plan contributions, are subject to this limit. There are rules unique to 529 plans which allow the gift tax exclusion for the next five years to be taken in the current year by making an election on your gift tax return. Using this election you could make a contribution of $70K ($140K for a married couple) to a 529 plan for a single beneficiary in the current year.