Financial Planning For Minors: Custodial Roth IRA’s VS 529 Savings Plans

With college costs continuing to soar, parents are looking for savings options that give them the best opportunity to fund their children’s college expenses. Since its inception, the 529 College Savings Plan has been the conventional choice due to its tax advantages. However, many parents are looking closely at the Custodial Roth IRA due to its potentially greater flexibility. Which is the right option for you? 

A Quick Overview of the 529 College Savings Plan[i]

The 529 plan is a popular choice for its tax advantages. Though after-tax dollars are used to fund the plan, funds grow tax-free, and when used to cover eligible school expenses, they can be withdrawn tax-free. Qualified expenses include tuition, fees, books, room and board. 

You can use 529 plans to pay educational costs at all secondary education institutions, including apprenticeship programs, and were recently approved to cover private K through 12 education costs. While there is no limit on the withdrawals taken to cover college education costs, K through 12 expenses are limited to $10,000 per year.[ii] 529 plan funds can also be used to pay down student loan debt of the plan’s primary beneficiary or their siblings up to a maximum of $10,000 per loan.[iii] 

While there is no limit on how much parents, grandparents, or other family members can contribute to a 529 plan, contributions over the annual gift tax exemption ($17,000 for individuals and $34,000 for married couples in 2023) may be subject to the federal gift tax. However, parents can “frontload” the plan with up to five years’ contributions ($85,000).[iv]

If a child changes plans and doesn’t attend college or has funds left over, parents can change the beneficiary to another child or use funds to pay down student loans up to $10,000 per loan for the primary beneficiary and their siblings.[v]

Before the passage of the SECURE Act in 2020, any funds withdrawn that were not used for college expenses were taxed and penalized. That posed a significant problem for parents when funds were left over in the plan, or a child changed their plans about going to college. The new law allows up to $35,000 of unused funds to be rolled over to a Roth IRA, which can be used to fund retirement.[vi]

529 plans are offered by various states, though you aren’t necessarily limited to investing in any one plan. You can shop around for a plan based on fees and performance. You may find a wider range of investment options in a program from another state. However, many states also offer a tax deduction for contributions made by in-state residents. 

One major complaint about 529 plans is their limited investment options and high fees. But you can shop and compare plans among the various state options to find one with lower fees and better investment options. 

Quick Overview of a Custodial Roth IRA[vii]

Roth IRAs have gained popularity in recent years due to their tax benefits and flexibility. Contributions to a Roth IRA are made with after-tax dollars, but they grow tax-free. After the age of 59 ½, funds can be withdrawn tax-free without penalty. Many parents are discovering that Roth IRA funds may also be used for college expenses—tax-free and without penalty, with certain restrictions.

Parents can establish a Roth IRA in the name of their children under the age of 18 for the purpose of jumpstarting their retirement savings or as a source of education funds. The parents control the Custodial Roth IRA until the child turns 18, after which they take control.

The major downside to a Custodial Roth IRA as a college savings vehicle is that the child must have reportable income to contribute and there’s the five-year rule on distributions. Since a child can’t start earning reportable income until age 14, as labor laws allow, that limits the amount that can be contributed by the time they enter college. 

Is It Just Hype?

There’s so much hype about custodial Roth IRAs on social media right now, and we are here to tell you it might just be the next trendy financial topic “fin-fluencers” are touting for media coverage. In reality, the earned income requirements for custodial Roth IRAs are stringent, and the burden of proof in tax court is on the taxpayer. This means your child must actually be doing whatever you claim they are doing to earn their income. Plus, the maximum IRA contribution in 2023 is only $6,500 on earned income documented on the child’s tax return. That is a drop in the bucket compared to the $418,000 per child maximum balance of a Florida 529 plan.

Custodial IRAs sound clever, but compared to the 529 benefits—which include a one-time Roth IRA conversion starting in 2024—we believe the 529 savings plan offers more flexibility and fewer potential tax headaches.

Personally, we have Florida prepay for four years at a state university for our children and a 529 plan for potential excess needs like rent, private K-12 education, or processing the special rollover.

It’s critical to keep in mind that government laws and regulations are fluid, often changing with the political winds. Working closely with a financial advisor who keeps their fingers on the pulse of tax law changes would be essential. 

If you are investing in or are about to invest in the education of your child or grandchild, we’d love to guide you. If family is as important to you as it is to us, we know you’re looking for the best way to help. We also know that doubt and second-guessing can foil even the greatest intentions. So don’t hesitate. Reach out today to get started.