A common dilemma financial advisors face is advising their clients on choosing between a custodial account and a 529 plan for their children. When clients are ready to plan their children's future, they often don’t know which would better benefit their children’s financial well-being.
This article will help answer any questions you may have and thoroughly clarify the advantages and disadvantages of each plan so that you can help your clients make an informed decision. We’ll also break down each plan from tax implications to key features and take a look at some examples and a case study.
Custodial Accounts vs. 529 Plans: Quick Comparison
Custodial Accounts: All You Need to Know
Let’s start with custodial accounts. A custodial account, such as a Uniform Gift to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) account, allows an adult to manage and invest money on behalf of a minor. The child gains complete control of the account once they reach the age of majority, typically 18 or 21, depending on the state. These accounts are often used for gifting money to children, investing for their future, and even tax-planning strategies.
Key Features
- Custodial accounts can hold various assets, including stocks, bonds, mutual funds, real estate, and cash. This allows advisors to craft portfolios suited to long-term growth.
- Once the child reaches the age of majority, they gain complete control over the account and can use the funds for any purpose. This offers flexibility but may pose risks if the child is not financially responsible.
Tax Implications
- The earnings in the custodial account are taxed at the child’s income tax rate, typically lower than the parents' rate, making it a potential tax-saving tool. However, this tax rate applies to unearned income over a certain threshold, which may partially negate these benefits.
- Unlike a 529 plan, a custodial account doesn’t offer specific tax benefits for education expenses.
Pros for Your Client
- Flexibility in Use: As mentioned above, the funds can be used for any purpose once the child comes of age—whether it’s for education, starting a business, or personal needs.
- Investment Versatility: Custodial accounts offer a broader range of investment options, allowing you as an advisor, to tailor strategies based on the client’s risk tolerance and goals.
Cons for Your Client
- Loss of Control: Once the child reaches adulthood, they can use the funds as they please, which may not align with the parents' original intent.
- Financial Aid Impact: Because custodial accounts are considered the child’s asset, they can significantly reduce financial aid eligibility, as they carry a higher weight in need-based financial aid calculations. For instance, if they apply for financial aid at their desired college when the time comes, having a custodial account may make it harder to prove their case about needing financial aid in the first place.
529 Plans: All You Need to Know
A 529 plan, on the other hand, is a state-sponsored savings plan designed to help families set aside funds for future educational expenses. Contributions to a 529 plan grow tax-deferred, and withdrawals are tax-free as long as the funds are used for qualified educational expenses, which include tuition, books, and room and board.
Key Features
- One of the primary advantages of a 529 plan is that withdrawals are tax-free if used for qualified education expenses. If the funds are used for non-education purposes, a 10% penalty and income tax apply to the earnings portion.
- While the investment options in a 529 plan are more limited than those in a custodial account, they typically include professionally managed mutual funds and ETFs (exchange-traded funds).
Tax Implications
- Tax-Free Growth: The most significant advantage of a 529 plan is its tax-deferred growth and tax-free withdrawals for qualified education expenses. These tax benefits make 529 plans a powerful tool for saving for college and K-12 tuition.
- Penalties for Non-Education Withdrawals: As mentioned earlier, if the funds are used for non-qualified expenses, the earnings will be taxed at the recipient’s tax rate, and a 10% penalty will apply to those earnings.
Pros for Your Client
- Significant Tax Advantages: 529 plans offer substantial tax savings on growth and withdrawals when used for education, making them ideal for clients focused on education planning.
- Lower Financial Aid Impact: Since 529 plans are considered parental assets, they typically have a lower impact on financial aid eligibility than custodial accounts. However, universities still consider parents’ assets when qualifying the suitable candidates for financial aid.
Cons for Your Client
- Restricted Use: Funds must be used for qualified education expenses, or clients will face penalties. This makes the account way less flexible than a custodial account.
- Limited Investment Choices: The investment options are usually limited to the selections offered by the plan, which can reduce the flexibility advisors have in customizing portfolios.
Which Account Is the Right One for Your Client?
Choosing between a custodial account and a 529 plan depends largely on your client's financial goals and their expectations for their children’s future. As a financial advisor, your recommendation will vary based on the flexibility your client seeks, the potential uses of the funds, and whether education is the primary objective or not. Let’s explore scenarios in which each account might be more suitable.
When to Recommend a Custodial Account
Custodial accounts are ideal for clients who want to offer their children broader financial options for the future. Since custodial accounts are not limited to educational expenses, they provide more flexibility regarding how and when the funds can be used.
Example 1
If your client is a successful entrepreneur and wants to set aside funds for their child but isn’t sure whether the child will attend college, a custodial account will be a better option.
The client may want to give the child the freedom to use the funds to start their own business, invest in real estate, or even purchase a home when they come of age. The custodial account offers them the freedom to do so since it allows the child to access and use the funds for a wide range of purposes once they reach adulthood.
Example 2
If your client has significant knowledge of the stock market and wants more control over how their child's savings are invested, a custodial account would allow the advisor to work with the client to build a custom portfolio that includes individual stocks, bonds, or mutual funds, aligning with the family’s investment preferences and risk tolerance. This makes custodial accounts more attractive to clients who want tailored investment strategies beyond the limitations of a 529 plan.
When to Recommend a 529 Plan
A 529 plan is the clear choice for clients whose primary goal is to save for their children’s educational expenses. The tax benefits associated with 529 plans make them highly advantageous for families focused on college or other post-secondary expenses.
Example 1
Let’s say your client strongly values higher education and is confident that their child will attend college. In this case, a 529 plan makes sense, as it allows the client to save for education in a tax-efficient way.
The client can contribute significant amounts to the plan over time, knowing that the funds will grow tax-free and that withdrawals won’t be taxed as long as they’re used for qualified educational expenses. This setup aligns perfectly with the client’s long-term goals for their child.
Example 2
Another scenario could involve a family planning to apply for financial aid. Since 529 plans are considered a parental asset, they have a lower impact on the child’s eligibility for need-based aid than custodial accounts. For example, a family with modest means who expects to rely on financial aid would benefit from setting up a 529 plan, ensuring their savings do not significantly reduce the aid their child might receive when applying for college.
How Feathery Can Help
Managing custodial accounts and 529 plans can be an administrative burden for financial advisors. Manually gathering client information, exchanging documents over email, and ensuring that every form is accurately filled out often results in inefficiencies. This leads to incomplete forms, incorrect data entry, and NIGOs (Not-In-Good-Order) submissions, which delay account openings and create additional work for advisors and their clients.
Feathery addresses these pain points by automating the entire account opening and management process. Rather than manually passing PDFs back and forth between advisors and clients, Feathery automates workflows with a digital client experience and direct document and API integrations with major custodians, including Fidelity, Schwab, and Pershing. This eliminates the need for manual data entry, reduces errors, and ensures that forms are correctly filled out from the start, preventing NIGOs and accelerating the onboarding process.
Here’s how Feathery’s solutions can make a difference for you:
- Automated Custodial Account Openings and Transitions
Feathery automates the setup of custodial accounts by pre-filling forms with existing client data, drastically reducing the need for manual input. This is especially helpful during advisor transitions, where new advisors can easily onboard clients by utilizing the existing client information, ensuring seamless transitions without delays or errors.
- Elimination of Manual Data Entry
Financial advisors can spend countless hours manually entering client data into PDFs, which takes time and increases the likelihood of mistakes. Feathery automates this process by scanning client-provided investment reports and documents, automatically populating the necessary fields, and syncing this data with custodians and wealth management platforms.
- Integration with Major Wealth Tools
Feathery offers bi-directional data syncing with popular wealth management systems like Salesforce, Orion, Redtail, and eMoney. This ensures that all client information is consistent across platforms, reducing the need for duplicative data entry and minimizing the risk of outdated or incorrect information.
- Dramatic Reductions in NIGOs
By automating data entry and ensuring that forms are correctly filled from the beginning, Feathery helps advisors dramatically reduce NIGOs (failed account openings due to incomplete or incorrect information). This leads to faster account setups and fewer delays in onboarding clients.
“Our clients have seen dramatic reductions in time spent passing PDFs back-and-forth with clients, manually entering data, and handling account opening NIGOs.” — Peter Dun, Founder & CEO at Feathery
- Scanning and Pre-filling of Investment Reports
Feathery can automatically scan client investment reports to intake and organize a client’s existing portfolio. This enables advisors to quickly understand a client’s financial position and offer relevant investment advice without the back-and-forth that typically accompanies manual data gathering.
How an RIA Cut Custodial Account Opening Time by 34% with Feathery
An RIA managing $8 billion in assets partnered with Feathery to eliminate the hassle of manually opening custodial accounts. Previously, their advisors were stuck in a tedious back-and-forth of exchanging PDFs with clients, often resulting in missing or incorrect information and frustrating delays.
Feathery stepped in with an automated, seamless process that gathers all the necessary data through smart, user-friendly forms and directly integrates with Schwab to auto-fill and submit the required documents.
On top of that, Feathery synced client data across their entire tech stack—Salesforce, Orion, and eMoney—creating a smooth, efficient workflow.
The result? A 34% reduction in account opening time, allowing the RIA’s advisors to focus more on clients and less on paperwork.
“We've significantly reduced back-and-forth cycles between advisors and clients, making the onboarding process more enjoyable on both sides.” — Chief Operating Officer
Your Next Steps
We suggest thoroughly analyzing each plan's benefits and downsides and comparing them against your clients’ needs. In some cases, you might want to explore a hybrid approach—using both types of accounts—which may offer the best balance of flexibility and tax benefits for some of your clients.
Next, we suggest taking a look at Feathery’s solutions (most of which are mentioned above) and see how we can help streamline the account-opening process, reducing time spent on administrative tasks and improving your client onboarding.
FAQ
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There is no one-size-fits-all answer. A custodial account offers more flexibility for how funds can be used once the child reaches adulthood, while a 529 plan provides significant tax advantages if the money is used for qualified education expenses. The right choice depends on the client’s specific goals and the child’s anticipated financial needs.
The biggest disadvantage of a custodial account is the loss of control once the child reaches adulthood. At that point, the child can use the funds for any purpose, which may not align with the original intent of the parents. Additionally, custodial accounts are considered the child’s asset, which can negatively impact financial aid eligibility.
Yes, the earnings in a custodial account are subject to taxes. The income generated by the assets is taxed at the child’s rate, which can be advantageous for smaller amounts. However, if the earnings exceed a certain threshold, they may be subject to the "kiddie tax," which taxes the earnings at the parent’s rate.
No, once money is placed in a custodial account, it is considered the child’s asset. The funds must be used for the child’s benefit, and the parent cannot withdraw money for their own personal use. However, parents can manage the investments and oversee the account until. the child reaches the age of majority, at which point the child gains complete control of the funds. Any use of the funds before that must be for the direct benefit of the child, such as education, healthcare, or other necessary expenses.
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