Custodial Accounts vs. 529 Plans

My wife and I would like to start college accounts for our grandkids. We had custodial accounts for our kids in the 1980s, but those accounts seem to be out of favor now. What vehicle gives our money the best chance to grow over 20 years while minimizing taxes? We plan to open each account with $1,000 and have $50 automatically deposited each month. Financial aid is not a concern. --Doug and Deb Scharp, Portage, Mich.

Custodial accounts—called UGMAs, after the Uniform Gifts to Minors Act, or UTMAs, after the Uniform Transfers to Minors Act—are a less-attractive way to save for college than they once were. Until a few years ago, these accounts were taxed at the kids’ low rates; now any investment income above $2,000 for children younger than 19 and full-time students younger than 24 is taxed at the parents’ higher rate. The first $1,000 of the child’s investment income in 2013 is tax-free, and the next $1,000 is taxed at the child’s own rate.

Money in a 529 plan, by contrast, grows tax-deferred, and the earnings can be used tax-free for qualified college costs. You may also get a state income tax break for your contributions. To qualify for the state tax break, you generally need to contribute to your own state’s 529 plan (although Arizona, Kansas, Maine, Missouri and Pennsylvania allow a deduction for contributions made to any state’s plan). Some states let anyone take a tax deduction for their contributions; others give the tax break only to the owner of the account. In Virginia, the account owner even gets the break on contributions to the plan from nonowners.

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In states where only the owner gets the tax break, it’s a good idea for parents and grandparents to open separate accounts so they can both deduct their contributions. There’s no limit on the number of 529 accounts that can be opened for one child. See www.savingforcollege.com for details.