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.

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.