Saving for College – Which Investment is Right for You? Part V ESA and Custodial Accounts

By: Abigail Warren, Fall 2017 IAC Student Intern

This final part to the college savings series covers two alternatives to 529 Plans – Coverdell Education Saving Accounts (ESAs) and Custodial Accounts.  While both accounts offer more investments options than 529 Plans, each one has distinct characteristics.


If you are looking for wide-open investment options, ESAs might be right for you.  You can set up an ESA at any brokerage firm, mutual fund or financial institution and select your own investments, with the exception of life insurance contracts, allowing you to tailor your account to meet your specific needs.  The fees vary, depending on your investment option and the selected institution.  The earnings in your ESA grow tax-deferred and you can withdraw money tax-free for qualified education expenses.  You can even use the money towards private elementary and high school expenses.  While these benefits are appealing to some, ESA’s have restrictions that might make some investors pass.

ESAs have a low contribution limit of $2,000 annually and income limits apply.  So, if your Modified Adjusted Gross Income (MAGI) is over a certain amount, you won’t be able to contribute that year (for more information on contribution and income limits see FINRA).  FINRA explains that while ESAs have an age limit, restricting contributions to those made before the beneficiary reaches the age of majority, exceptions exist for those with special needs.  An age limit also applies to the distribution of funds – you must distribute the funds within 30 days of the beneficiary’s  30th birthday.

Custodial Accounts

Two types of custodial accounts exist – Uniform Gift to Minors Act (UGMA) accounts, and Uniform Transfer to Minors Act (UTMA) accounts.  UGMA accounts allow only cash gifts and securities, while you can hold other types of property, including real estate, in a UTMA account.

FINRA explains how you can set these accounts up at any financial institution and the custodian can be a parent, grandparent, or other adult and need not be the donor – the donor can appoint a custodian.  The custodian will make all decisions regarding the account until the beneficiary reaches the age of majority.  Custodial accounts offer tax advantages, depending on the amount of unearned income and the child’s age (for more information on tax advantages see FINRA), however, these accounts are not tax-deferred, and withdrawals are not tax-free.  FINRA notes that the custodian is also subject to the federal gift tax.

Some perks of custodial accounts include more investment options, no contribution or income limits and, unlike 529 plans and ESAs, you can use withdrawals for any purpose.  That’s right. If your child doesn’t use the money for tuition, they can use it for something else.  While the ability to freely spend sounds enticing, disadvantages come with this freedom.  For starters, at the age of majority, your child/beneficiary gains control over the account, enabling them to use the money as they wish.  FINRA explains that a custodial account is an irrevocable gift, with only one custodian and one beneficiary.  Funds cannot be transferred to another family member’s name; the beneficiary owns all contributions.  However, you can transfer the funds tax free to a custodial 529 plan, but the beneficiary must stay the same, and you must liquidate investments and pay taxes on gains.