With a custodial account, a beneficiary’s money is managed by a responsible party on their behalf. Often, though not always, the responsible party is the parents or guardians of a minor who has either been gifted money or is part of a college savings plan. The responsible party, or fiduciary, is legally required to act in the best interests of a child.
A custodial account allows a minor to save and invest. Two of the more common custodial account options are UTMA and 529 accounts, but which is the best custodial account? In order to discern which one is right for your minor, let’s delve into the features of these custodial accounts and their different benefits.
What Is a 529 Account?
A 529 account is a tax-advantaged savings account designed to encourage saving for higher education. It is a college savings plan to be used for a beneficiary’s educational expenses and is sponsored by the state or a state agency. Savings can be used for tuition as well as other qualified expenses, such as books, computer equipment, and room and board. Typically, when you enroll, you receive a starter kit detailing the full list of qualified expenses covered by your state’s plan.
To avoid taxes and penalties, use the account for these qualifying expenses and make sure to keep the withdrawals in the same calendar year as the expenses. This way, you can easily make withdrawals that are federal income tax-free and penalty-free. Cover educational expenses or reimburse yourself for costs paid out of pocket. If you need to make a withdrawal for a non-qualified expense, you will be able to, but be aware you will be subject to a 10 percent penalty as well as owe federal income tax on these non-qualified withdrawals.
Funding a 529 plan allows your money to grow tax-deferred, which in turn enables tax-free withdrawals. Anyone can open or contribute to a 529 account on behalf of the beneficiary. Parents, grandparents, other relatives, and friends can all contribute. Plus, 529 plans extend to technical and vocational schools, as well as K-12 tuition.
Benefits of a 529 Plan
In addition to the aforementioned benefits, 529 plans offer several tax-free financial benefits:
- Flexible educational opportunities: Fund higher education such as college, pay for K-12 education, apprenticeship programs, technical, or vocational schooling.
- Tax-deferred growth with tax-free withdrawals: Grow money without paying taxes on the savings and make qualified tax-free withdrawals.
- Beneficiaries can change over time: Use the same account for multiple minors or fund an adult going back to school. Use a 529 account for siblings; each can take turns using the funds, provided it’s not at the same time. Make sure to carefully look at the account’s terms to avoid penalties.
- Small impact on financial aid eligibility: Since the account is not owned by the minor, and is instead owned by the fiduciary, there is little impact on federal financial aid eligibility.
- Unused funds can be rolled over to a Roth IRA for retirement: Under the SECURE 2.0 Act, beneficiaries of 529 accounts that have been open for at least 15 years can transfer these funds without paying taxes or penalties.
What Is an UTMA Account?
The Uniform Transfers to Minors Act (UTMA) allows minors to receive gifts such as money, patents, fine art, royalties, or real estate without the aid of a guardian or trustee. An UTMA account enables the gift giver or custodian to manage a minor’s account while avoiding tax consequences on the gift until they are of legal age. This way, a parent, relative, or other adult can pass on gifts to minors without having to set up a formal trust, while increasing tax savings on these assets.
Typically, the gift giver manages these assets as the official custodian unless they appoint a third party to act as custodian. Once the minor is of legal age, the UTMA account is transferred to them.
Benefits of an UTMA Account
UTMA accounts provide flexibility in investing. Some of the main advantages of an UTMA account include:
- Significant tax saving: Money contributed to an UTMA account is exempted from paying a gift tax up to a certain amount per year. Earned income from the funds is taxed according to the tax rate of the minor, which is lower than the adult gifting these assets.
- Invest in high-return assets or traditional assets with custodial accounts: These can include stocks or CDs and can also be used to invest in real estate.
- Flexible financial options: Without the limited spending categories of a 529, money from an UTMA account can be used for more than educational expenses but can be rolled into a 529 plan if necessary.
Choosing the Best Custodial Account
With every financial option, there are benefits and drawbacks that must be considered. Both types of accounts provide opportunities for minors to invest and save, so which is the best custodial account for your beneficiary? This will depend on the financial goals of both the beneficiary and the custodian.
If education is the purpose of the savings plan and the beneficiary qualifies for financial aid, then the 529 plan is a great option and may be the preferred account. UTMA accounts have a significant impact on financial aid and may hurt eligibility, such as need-based scholarship programs.
However, if a minor prefers flexibility without limited spending categories, then an UTMA account may be the better fit. UTMA accounts can be used for educational expenses but is not a requirement. Once a minor is of legal age, the assets are theirs to spend on whatever they choose. With a 529 plan, there may be some risk of losing unused funds or paying penalties to withdraw the remaining balance. Discuss financial goals to choose the best custodial account for your savings needs.
At Capital Credit Union, we have savings account options that work best for your lifestyle and goals. Whether you are an adult or minor saving and investing for the future, we have a plan that sets you up to win. Becoming a member is easy, join today and start saving.
