The two most common ways to save for your child’s college education are 529 plans and custodial brokerage accounts. In order to decide which one of these works better for your family, it is important to know the difference between these accounts. In this blog, we will cover the pros and cons of 529 plans, as well as custodial brokerage accounts for college savings.
How do 529 plans work?
A 529 plan is a college savings plan that allows an owner to set aside funds for future education expenses. These are often opened by parents for their children’s future education. Post-tax funds can be contributed and invested in the 529 plan (post-tax means you don’t take a federal tax deduction in the year you contribute). When used for qualified education expenses, the growth in the account comes out tax-free upon withdrawal.
The taxation of this account is what makes it a great college savings vehicle. The longer the funds are invested, the more potential the account has to grow, which means more tax-free money upon withdrawal. Some states offer a state tax deduction in the years that you deposit funds into a 529 account, which adds to the taxable benefits.
To open a 529 account, you choose a state 529 plan to start contributing to. Each state has their own 529 plan. You can then open the account and add the child as a beneficiary. Anyone can then begin contributing to this account.
It does not matter which state you live in or the state the child attends college, you can choose any state 529 plan. Keep in mind, if you live in a state that offers a state tax deduction, you would likely want to open the 529 plan in your state, except when the fees of that 529 plan are high.
How do brokerage accounts work?
Brokerage accounts are regular investment accounts you can use to invest money. Funds in this account are not locked into a retirement account or a college savings account, so they can be added or taken out at any time with no tax penalty. Once money is added to a brokerage account, the owner can then trade in the stock market, and buy mutual funds, bonds, index funds, and more.
A brokerage account is not a retirement account or education account, therefore there are no specific tax benefits to using this type of account for either of these expenses. You have to pay taxes on dividends and capital gains (if any) each year.
Some families choose to use a custodial brokerage account to save for their children’s education because it is more liquid, and the money is not tied to college education. There are no penalties if the parents end up not using it for college (say if the child gets a full scholarship). There are pros and cons in using a custodial brokerage account.
Is a 529 a brokerage account?
A 529 is not a brokerage account. A 529 plan is a college savings account that is specifically meant for higher education expenses. Brokerage accounts have many uses and are not only for college savings accounts. There are some key differences between a brokerage account and a 529 plan, which we will discuss below.
What are the differences between a 529 plan and a brokerage account?
|529 Plan||Brokerage Account|
|Financial Aid||more favorable on the FAFSA application because they are not owned by the student.||if it's held in the name of the parents, the calculation would be the same as with the 529 plan owned by the parents. If the money is in a custodial brokerage account, that is technically the child's assets.|
|Beneficiaries||The beneficiary is the student which the funds are meant for.||The beneficiary depends on the owner of the account. If the owner is the parents, they remain owners as long as they are alive or keep the funds in their own account.|
|Lifetime contribution maximum||no specific lifetime contribution maximum but some states do have a maximum amount that can be in a 529 account.||There is no lifetime contribution maximum for a brokerage account.|
|Gift tax||For both 529 plans and brokerage accounts in the name of the child, the first $16,000 per person added to these accounts is excluded from gift tax.||For both 529 plans and brokerage accounts in the name of the child, the first $16,000 per person added to these accounts is excluded from gift tax.|
|Tax benefits||the beneficiary never owns the account, and therefore never pays taxes.||Dividends from investments in brokerage accounts are taxed at ordinary income rates. Capital gains tax rates apply when investments are sold at a gain.|
Let’s explore the 529 vs brokerage account differences in depth
529 plans are more favorable on the FAFSA calculation (Free Application for Federal Student Aid) because they are not owned by the student. The student is the beneficiary. Generally, 529 plans are owned by parents, but can be owned by anybody and have any beneficiary. FAFSA (Free Application for Federal Student Aid) considers assets owned directly by the student to be more heavily weighted than money in the names of parents when determining student need.
If a brokerage account is held in the name of the parents, the calculation would be the same as with the 529 plan owned by the parents. Only 5.64% of the brokerage account assets are counted towards the Expected Family Contribution (EFC).
If the money is in a custodial brokerage account, that is technically the child’s assets. Thus, federal financial aid formulas count 20% of the money as available to pay for college. Contrast this to 529 plans, where the formula only counts 5.64% of the money to be available in a parent-owned 529 plan.
The beneficiary of a 529 plan is the student which the funds are meant for. The funds in a 529 plan are owned by one person and generally, the beneficiary is another. The beneficiary can receive these funds at any point that the owner decides they can be distributed for higher education expenses.
The beneficiary is not entitled to these funds at any point. The owner always has control over the funds and does not have to distribute them to the beneficiary. In addition, the beneficiary can be changed in a 529 plan to another family member. Even the owner can use the funds for his or her own education expenses.
The beneficiary of a brokerage account depends on the owner of the account. If the owner of the brokerage account is the parents, they remain owners as long as they are alive or keep the funds in their own account. A beneficiary in an account like this is named in the event that the owners die while there are still funds in the account. If the owners do pass away, the funds then become owned by the beneficiaries.
If the brokerage account is titled in the name of a minor, such as a UTMA (custodial) account, the custodian of the account remains in control as long as the child is still a minor. As soon as the minor reaches the age of majority for their state, the funds legally become theirs and the custodian no longer has any say in what is done with the money. The funds do not have to be used for college education or any specific purpose.
Lifetime contribution maximum
There’s no specific lifetime contribution maximum for a 529 account. Some states have a maximum amount that can be in a single 529 account, which often ranges from $300,000-$500,000.
There is no lifetime contribution maximum for a brokerage account.
For both 529 plans and brokerage accounts in the name of the child, the first $16,000 per person added to these accounts is free from filing a gift tax form. The federal gift tax exclusion yearly is $16,000 in 2022. For example, if you and your spouse both want to add to a 529 account and maximize your annual gift tax exclusion, each of you can put in $16,000 for a total of $32,000 each year into each child’s 529 plan and not worry about any gift tax filing.
You can also front-load 529 plans for your child up to 5 years. This means you can give 5 years’ worth of annual gifts of up to $16,000 at once ($80,000 total per person, per beneficiary), without having to file a gift tax form.
In addition, grandparents or anyone else can also add $16,000 each into the child’s 529 account to take care of their own annual gift tax exclusion. Gifts can also go towards a brokerage account. Keep in mind, the $16,000 annual gift tax exclusion is per person, not per account. If a single taxpayer added $16,000 to a brokerage in the child’s name and also to a 529 with the same beneficiary, they would have to file a gift tax return for $16,000 because they gifted above the annual exclusion to the same person.
If you do gift over $16,000 in one tax year to one person, the amount above $16,000 will start counting against the federal estate and gift tax exclusion. This exclusion is currently $11.7 million that can be gifted over a lifetime and at death combined. If you aren’t going to gift this amount over your lifetime and at death, you won’t need to pay gift taxes on money put into either of these accounts, but you will need to file a gift tax form each year that your contributions exceed the annual gift tax exclusion.
In a 529 account, the beneficiary never owns the account, and therefore never pays taxes. In addition, as long as the growth in the account is used for qualified education expenses, the growth comes out completely tax-free. This could be a significant tax saving for families who would like to save on taxes and pay for their child’s higher education expenses.
Dividends from investments in brokerage accounts are taxed at ordinary income rates. Capital gains tax rates apply when investments are sold at a gain.
Capital gains rates are taxed differently depending on how long an investment was held. For example, if you purchase a stock today and sell it three months from today at a gain, the gain on the stock will be added to your taxable income and paid at your marginal tax rate. This is a short-term capital gain.
If you purchase a stock today, and wait to sell it for at least 12 months and one day, the growth realized in the sale will be paid at long-term capital gains tax rates, which are much more favorable than short-term capital gains rates.
Who can contribute to a 529 or brokerage?
Keeping in mind the gift tax rules discussed above, anyone can contribute to either of these accounts.
Is 529 better than a brokerage account?
This depends on the goals for the account. If you would like the child to be able to use the funds for any purpose, and not just education, a brokerage account may be the way to go.
If you would like the funds to only be used for education, and you would like to keep control of the funds even after the child is an adult, a 529 plan is a great option.
Start saving for college with a 529 or brokerage account today!
There are pros and cons to both 529 plans and brokerage accounts. A 529 has better tax advantages when used for college education while brokerage accounts have more flexibility when it comes to using it for multiple purposes. If you want help with your finances and are interested in having a comprehensive financial plan, feel free to schedule a discovery call with one of our financial advisors today!
Shanna Due, AFC® is a fee-only financial planner based in Williamsburg, Virginia. She uses her Master’s degree from the University of Northern Colorado, her certifications, and two decades of experience to help professionals in their 30s and 40s achieve their financial goals. She does this through goal-oriented savings and investing, reducing taxes, planning for retirement, and mitigating risk. To find out how she and the team of District Capital Management can help you schedule a free discovery call.