Education IRAs & Custodial Accounts

Custodial Accounts
Money that goes into a custodial account is an irrevocable gift belonging to the child. The advantages have been that putting money into the account lowers the family's total taxable income, and that the first $750 in earnings are tax-free and the next $750 in earnings are taxed at the child's tax rate (usually around 10 percent). The disadvantages are that you can't take the money back in the event of an emergency. The money can be used for the child's benefit but not for your own or your family's (i.e., unemployment, vacation, home improvements). You can probably get away with using the money that way, but the child has the legal right to fight the decision. Another disadvantage is that the child can spend the money on anything once he or she reaches either 18 or 21 depending on your state's age requirement. Financial aid eligibility creates yet another disadvantage for custodial accounts because when the money is in the child's name, then 35 percent of it will be considered an asset available for college costs, possibly making the child ineligible for financial aid.

Education IRAs
Now known as Coverdell Education Savings Accounts, ESAs were improved significantly in 2002 because Congress increased the annual contribution limit from $500 to $2,000. Like 529 plans, ESA earnings are tax-free when used for education expenses, and they are considered the parents' asset so they don't adversely affect financial aid eligibility.

They do have some advantages over 529 plans, including more control over your investments and the ability to use the money for private elementary or secondary school expenses.

Their disadvantages are the limitations on parents' income. For single tax payers, the eligibility phases out for incomes between $95,000 and $110,000. For married taxpayers filing jointly, eligibility phases out between $190,000 and $220,000. Another disadvantage is that the funds have to be used for education by the time the beneficiary turns 30. Like the 529, there is a 10-percent penalty if the money is used for anything other than education expenses.

Converting a Custodial Account to a 529
You can convert your existing custodial account to a 529 account, but it won't have the same benefits. The problem is that the money in the custodial accounts belongs to the child, and therefore will still belong to the child when it is converted to the 529. That means that the child will still gain control of the account at 18 or 21 and have the opportunity to cash out (paying taxes and penalties) and then use the money for anything.

For more information on 529 plans and other college savings topics, check out the links on the next page.