While the value of a college education is priceless, earning a degree often comes with a hefty price tag. Parents who want to get started saving early for their child's college costs have several alternatives to choose from, including 529 plans and custodial savings accounts. There are several key differences between the two and parents should weigh the pros and cons of each when choosing the best savings option.
529 Plan Defined
The Internal Revenue Service recognizes two types of 529 plans: college savings accounts and prepaid tuition plans. A 529 college savings account allows you to stash away cash for college costs while prepaid tuition plans allow you to buy future college credits at a locked-in rate. Money saved in either type of 529 plan may be used to pay for tuition, books, fees, supplies and room and board for a child, grandchild or other designated beneficiary attending an eligible institution. The IRS defines an eligible institution as any college, university or other institute of higher learning that is eligible to participate in federal student aid programs.
Custodial Account Rules
A custodial account is a special type of savings account that is established by an adult for the specific purpose of gifting money to a minor. The adult acts as the custodian for the account until the minor reaches the age of majority, at which time the account is transferred to their control. The age of majority is between18 and 21, depending on which state the minor resides in. Once the minor gains access to the money, he is free to use it for college expenses or for any other purpose.
Contributions to a 529 plan are not deductible on your federal taxes but you may be able to catch a break on your state taxes, depending on where you live. Distributions from a 529 are generally not taxable, unless you use the funds for a purpose other than education expenses.
Any earnings or dividends generated by assets in a custodial account are subject to the child's ordinary tax rate once he turns 18. If the child is under age 18, the first $950 in earnings are not taxable. The next $950 is taxed at the child's marginal rate and anything over this amount is taxed at the parents' rate.
Each state sets a different limit on how much you can contribute to a 529 plan. There are no contribution limits for custodial accounts and no restrictions as to who may establish one. Custodial accounts are treated as an asset of the minor when establishing student loan eligibility and can significantly affect the amount of aid your child qualifies for. Money held in a 529 plan is considered to be an asset of the parent and does not have a substantial effect on student aid eligibility. If your child doesn't use all of their money in his 529 plan, you can transfer the account to another beneficiary. Once you create a custodial account, you can't change the beneficiary.
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