Custodial IRA vs. 529: Choosing the Right Account
Understand how 529 plans and Custodial IRAs differ in asset control, contribution rules, and their distinct impacts on future financial aid eligibility.
When saving for a child’s future, two common options are the 529 Plan and the Custodial Individual Retirement Account (IRA). While both help build a nest egg for a minor, they have different frameworks, rules, and tax implications. Understanding these distinctions helps in selecting the account that best aligns with a family’s financial goals.
Understanding the 529 Plan
A 529 plan is a tax-advantaged savings vehicle specifically designed to encourage saving for future education costs. These plans are sponsored by states, and while you can typically invest in any state’s plan, some offer tax benefits for their own residents. Contributions grow on a federally tax-deferred basis, and withdrawals are completely tax-free at the federal level when used for qualified education expenses.
Contributions to a 529 plan are considered gifts for tax purposes. For 2025, an individual can contribute up to $19,000 per beneficiary without gift-tax consequences. “Superfunding” allows a contributor to make a lump-sum contribution of up to $95,000, representing five years of gifts, in a single year. This requires filing a gift tax return (IRS Form 709) to make the five-year election.
The definition of qualified expenses is broad. For postsecondary institutions, this includes:
- Tuition and fees
- Books, supplies, and equipment
- Room and board for students enrolled at least half-time
Recent changes also allow for up to $10,000 annually for K-12 tuition and a lifetime limit of $10,000 for student loan repayment. If funds are withdrawn for non-qualified purposes, the earnings are subject to ordinary income tax plus a 10% federal penalty.
The account owner, typically a parent or grandparent, maintains full control over the assets. This control is indefinite and does not transfer to the child upon reaching a certain age. The owner decides when to take distributions and for what purpose. If the original beneficiary does not pursue higher education, the owner can change the beneficiary to another eligible family member without tax penalty.
Understanding the Custodial IRA
A Custodial IRA is a retirement account established for a minor, managed by an adult custodian until the child reaches the age of legal majority. Its primary purpose is retirement savings, and the minor must have legitimate earned income to be eligible. This can include wages reported on a W-2 or documented self-employment income from activities like babysitting or lawn care.
Contribution limits are tied directly to this income. For 2025, contributions are capped at the lesser of the child’s total earned income for the year or $7,000. For example, if a child earns $3,000 from a summer job, their IRA contribution for that year cannot exceed $3,000.
These accounts can be established as either a Traditional or a Roth IRA. A Custodial Roth IRA is funded with after-tax dollars, meaning contributions are not tax-deductible, but qualified withdrawals in retirement are completely tax-free. A Custodial Traditional IRA may allow for tax-deductible contributions, with withdrawals taxed as ordinary income in retirement. Given that most minors are in a low or zero percent tax bracket, the Roth variant is often the more logical choice.
The custodian manages the account’s investments, but this control is temporary. Once the minor reaches the age of majority (18 or 21 depending on state law), the assets must be transferred to an individual IRA in their name, giving them full control. While the funds are intended for retirement, there is an exception for higher education expenses. Withdrawals for this purpose are exempt from the 10% early withdrawal penalty, though for a Traditional IRA, the earnings portion would still be subject to ordinary income tax.
Key Differences for Decision-Making
The accounts’ primary purposes dictate their flexibility. A 529 plan is an education savings tool, and its tax benefits are unlocked only when used for qualified education expenses. Using the funds for other reasons incurs taxes and penalties on the earnings. A Custodial IRA is a retirement account, offering broader flexibility once the child gains control, but with rules designed to encourage long-term saving.
Contribution eligibility is a deciding factor for many families. Anyone can contribute to a 529 plan for a beneficiary, regardless of the child’s income, allowing funds to be built from birth. The Custodial IRA is more restrictive, as contributions are strictly limited by the minor’s earned income for the year. A child with no documented earnings is ineligible for a Custodial IRA.
Asset control is another point of divergence. With a 529 plan, the account owner retains indefinite control over the funds, deciding how money is invested and distributed. In a Custodial IRA, the custodian’s control ends when the child reaches the age of majority. At that point, the former minor gains complete and irrevocable control over the assets to use as they see fit.
The treatment of these assets in federal financial aid calculations is also different. The Free Application for Federal Student Aid (FAFSA) determines a Student Aid Index (SAI) to measure a family’s ability to pay for college. A parent-owned 529 plan is a parental asset, assessed at a maximum rate of 5.64%. A Custodial IRA is a student asset and is assessed at a much higher rate of 20%, which can have a greater negative impact on financial aid eligibility.