Quick overview

Families saving for college or passing wealth to children commonly choose among three tools: 529 college savings plans, custodial accounts created under UGMA/UTMA, and trusts (revocable or irrevocable). Each option balances tax benefits, flexibility of use, control over distributions, and effects on federal student aid differently. In my 15 years advising families, I’ve seen the right choice depends on the family’s goals, assets, and appetite for complexity.

Side-by-side: key differences

  • 529 plan: Tax-deferred growth and federal tax-free withdrawals for qualified education expenses (see IRS Publication 970). Many states offer state tax deductions or credits for contributions, but state rules vary. Withdrawals for K–12 tuition are allowed up to $10,000 per year for federal tax purposes; states may treat K–12 distributions differently (IRS; check state rules).
  • Custodial account (UGMA/UTMA): Assets are transferred to a custodian for the minor. When the child reaches the statutory age of majority (usually 18 or 21, depending on state), the assets become the child’s outright property. No contribution limits, but earnings may be subject to the “kiddie tax” (IRS rules).
  • Trusts: Legal arrangements (revocable/irrevocable/grantor/non-grantor) that let a grantor set distribution rules, protect assets, and sometimes achieve creditor protection or estate tax planning. Trusts can be tailored to require funds be used for education, housing, or other purposes.

(For a compact comparison of education funding options and loans, see our guide: Education Funding Options: Comparing 529s, Custodial Accounts, and Loans.)

Tax treatment and growth

  • 529 plans: Investments grow tax-deferred and, when used for qualified education costs, withdrawals are federal income tax-free (IRS Publication 970). Qualified expenses include tuition, fees, books, supplies, and some room-and-board for students enrolled at least half-time. State tax benefits depend on the plan and your state of residence; some states limit deductions to their own plans.
  • Custodial accounts: Earnings are taxed to the child. Under federal “kiddie tax” rules, a child’s unearned income over a threshold is taxed at the parent’s marginal tax rate (IRS Form 8615 rules). Because the account belongs to the child at majority, capital gains and dividends are taxed in the child’s name until then.
  • Trusts: Taxation depends on the trust type. Irrevocable trusts are separate tax entities; trust income may be taxed at compressed trust tax brackets unless distributed to beneficiaries. Grantor trusts pass income through to the grantor for income tax purposes.

Impact on financial aid (FAFSA/CSS)

  • 529 plans: If owned by a parent, 529 assets are reported as parental assets on the FAFSA, which has a relatively modest impact on aid (up to ~5.64% of parental assets counted in expected family contribution calculations) (Federal Student Aid — studentaid.gov).
  • Custodial accounts: Counted as a student asset on the FAFSA once set up — student assets are assessed at a much higher rate (up to 20% each year), which can reduce need-based aid more substantially.
  • Trusts: Treatment depends on whether the trust is an asset of the student or someone else and on the distribution rules. A trust that can be tapped for the student may be treated as an available resource. Always check with financial aid advisors and read student-aid guidance.

Control and flexibility

  • 529: The account owner retains control over distributions and beneficiary designations. Funds must be used for qualified education expenses to avoid income tax and a 10% federal penalty on earnings (with exceptions for scholarships, death, disability). Beneficiary changes are permitted within family members.
  • Custodial accounts: The custodian manages the assets for the minor, but at majority the child gets full control — you cannot force them to use the funds for education.
  • Trusts: Offer the most control. You can require that trustees make payments directly to institutions or set milestones (e.g., release funds for tuition only). Trusts can also protect benefits for special-needs beneficiaries.

When each option often makes sense (practical guidance)

  • Choose a 529 plan when your primary goal is to save tax-efficiently for college or other qualified education costs and you want to retain control of distribution timing. 529s are efficient for parents and grandparents who want state tax incentives or simple administration.
  • Choose a custodial account if you want a flexible savings vehicle that the child can use for any purpose (education, car, travel) and you’re comfortable that the child will control funds at majority. Useful for small gifts and teaching financial responsibility.
  • Choose a trust if you need strict control over when and how funds are used, want to protect assets from creditors, qualify for special-needs protections, or must coordinate broader estate plans. Trusts are appropriate when families need customized distribution rules or are concerned about future heirs’ maturity or creditor exposure.

Hybrid strategies I recommend in practice

Many families use more than one tool. A common approach:

  1. Use a 529 as the core education fund for tax efficiency and modest FAFSA treatment.
  2. Fund a small custodial account for discretionary expenses and to teach the child financial habits.
  3. Use a trust if you want strict control or are passing significant wealth or protecting benefits.

In my practice I often see grandparents contribute to 529s (because 529 gifts from grandparents don’t count as parental assets if not disbursed in FAFSA’s base year), while parents maintain the primary accounts. For details on distribution timing and rollovers, see our article about 529 Plan Rollovers.

Real-world examples (anonymized)

  • Family A: Put monthly contributions into a 529 from infancy and qualified withdrawals covered most of tuition. The parents claimed their state deduction and avoided federal tax on distributions (IRS Publication 970).
  • Family B: Used a custodial account for extracurriculars and a first car. When the child turned 21, they used the remainder for a study-abroad semester — no restrictions but limited financial-aid help.
  • Family C: Set up an irrevocable trust that pays tuition directly to institutions. The trust protected assets from divorcing spouses and creditors and preserved funds for grandchildren.

Common mistakes and misconceptions

  • “529s are only for college.” False. 529 funds can pay for qualified K–12 tuition (up to certain limits under federal law) and some apprenticeship programs; state treatment differs (IRS; check your state plan disclosure).
  • “Custodial accounts are tax-free.” No — earnings are taxed and the kiddie tax can apply at parent rates.
  • “Trusts are only for the ultra-rich.” Not true — trusts are useful at many wealth levels when specific control or protection is needed, but they require trustee fees and legal setup costs.

Practical checklist before you pick a strategy

  • Define the goal: education only, general support, or estate planning/protection.
  • Estimate the likely college cost and gap you want to cover.
  • Check state tax benefits for your state’s 529 plan and residency rules.
  • Consider financial aid implications (FAFSA/CSS) and timing of distributions.
  • If choosing a trust, consult an estate attorney to select the trust type and draft clear distribution standards.

Next steps and questions to ask an advisor

  • Ask a tax professional about state-specific 529 tax breaks and how K–12 distributions are treated where you live (state rules vary).
  • Ask a financial aid advisor how custodial or trust assets will affect your child’s FAFSA and CSS Profile.
  • If using trusts, ask an attorney about trustee selection, administration costs, and tax consequences.

Internal resources

Authoritative sources and further reading

  • IRS Publication 970: Tax Benefits for Education (IRS.gov)
  • IRS information on the “kiddie tax” and Form 8615 (IRS.gov)
  • Federal Student Aid (studentaid.gov) — guidance on how assets affect FAFSA
  • Consumer Financial Protection Bureau: resources on paying for college and saving strategies

Professional disclaimer: This article is educational and does not replace personalized tax, financial, or legal advice. Laws and limits change; consult a qualified tax advisor, financial planner, or estate attorney before making binding decisions.

(If you’d like, I can create a one-page worksheet comparing these options for your situation — provide ages, state residency, and rough savings target.)