Generally I have been critical of 530 accounts (Trump accounts). However, today I did a study on tax drag for 530A accounts vs. taxable brokerage accounts and came to some interesting conclusions.
TLDR:
All the results are pretty close with 55-year tax drag amounting to 10-60 bps with a range of variables affecting this like the eventual tax bracket during the kid's retirement, state income tax, and so on.
Generally, like for like, the 530A account will do marginally better, but if managed properly the difference could be within 5-15 bps.
There is a relatively tax-efficient alternative to Roth conversions for 530A accounts. Instead of paying tax on conversions or letting them ride for 60 years, the basis and gains can be split out after age 18 at the first job with a 401(k). This can result in no tax owed while still moving all future growth on basis to Roth treatment, limiting the tax on the gains side. This strategy shaves off the best case scenario's tax-free upside for 530A accounts but is much easier to achieve from a tax perspective, perhaps as a fallback if taxed Roth conversions prove undesirable.
The choice between a 530A account and something relying on taxable brokerage treatment, like a UTMA/UGMA, depends on a range of factors not easily modeled, which are at the bottom of this post.
The Model
Let's assume we're talking about a stock fund with a gross return of 10% per year and a 1% dividend yield. I modeled the aftertax IRR on this investment across six tax scenarios. The basic fact was contribution of $100 for a kid at about age 5 which then compounds for 55 years and is withdrawn by the kid at age 60.
Here are the six tax scenarios:
Taxable brokerage account, no dividend tax drag
Taxable brokerage account, dividend tax drag paid out of cashflow
Taxable brokerage account, dividend tax drag paid out of portfolio
530A account, Roth conversions paid in years 16 and 17 of scenario (roughly junior and senior years of college)
530A account, no Roth conversions, taxable withdrawals at age 60
530A account, no Roth conversions, at age 23 split gains into traditional 401(k) and basis into Roth IRA, taxable withdrawals only on former at age 60
Note that the taxable brokerage account scenarios are intended to encompass a range of plausible options, including a UTMA/UGMA account, a trust, or gradual gifting of parent-earmarked stock.
To calculate the tax cost for the Roth conversions for the first 530A scenario, I separately estimated how much would be in the account for a kid whose 530A received the maximum $5,000 annual contribution for ages 5-18, earned 10%, allowed it to grow for two more years, then did Roth conversions for two years with no other taxable income. I got about $41K in income for each of the two conversion years with about $4100 in tax (including an estimate of state income tax), which was about 2.8% of the overall balance. This isn't supposed to be exact; it's a starting point.
To estimate tax for the second 530A scenario, I estimated the total portfolio at age 60 after 55 years using a 10% growth rate, then deflated that by a 3% inflation rate over 55 years. This resulted in about 99% of withdrawals being taxable income, which I then entered in a tax calculator (again including an estimate of state income tax), which resulted in a tax liability of about 12% of the withdrawal. Again, not exact--just a starting point.
To estimate tax for the third 530A scenario, I used mostly the same parameters but simply split the basis out at age 23 to grow into a Roth account while assuming the gain until that point was moved into a traditional 401(k) or similar account to continue grow on a tax-deferred basis.
I then varied the scenarios for various tax rates on the long-term capital gains liquidation for age 60 and tax costs as a % of account value for the 530A scenarios.
I used compounding growth on $100 as a simplification to avoid building full portfolio size and tax models for all scenarios since there are a great many variables that could arise over 55 or so years.
Findings
I found that at a 20% capital gains (roughly 15% federal and state 5%), the various taxable brokerage account scenarios ranged from 9.38% IRR to 9.55% IRR. The difference between these IRR values and the 10% growth rate of the stocks represents the ultimate tax drag, spread across dividend tax drag (if any) and long-term capital gains tax. Of course, regardless of ultimate capital gains tax, the scenario with no dividend tax drag had the highest taxable brokerage account tax drag, while the two scenarios with dividend tax drag had less, with the version paying it out of portfolio being 2 bps higher. However, if the kid ultimately recognized these sales at a 5% state income tax rate and 0% federal LTCG rate, the IRR ranges from 9.7% to 9.9%.
For the primary 530A scenario, I started with the tax cost at years 16-17 of a 2.8% tax cost (measured in terms of portfolio balance). Since the result is a Roth account, there is no more tax owed at year 55. That got an IRR of 9.89%. This result assumed no other income with conversions spread across two years, which benefits tremendously from the standard deduction in both years and which basically requires the kid to not qualify as a dependent on the parent's return for those years. What if the kid had a job or an internship in those years, or otherwise didn't have a full standard deduction? I tried a tax cost measured at 5% of portfolio value for those years and got 9.8% IRR. On the other hand, if the kid attends graduate school, it's entirely possible that the kid will eventually fall out of dependent status and may be able to spread out all Roth conversions in the standard deduction, which could result in an IRR of 9.95% (depending on state income tax).
For the second 530A scenario, I started with the 12% tax liability on 99% of the ending balance and got an IRR of 9.74%. This result depends strongly on the eventual withdrawal benefiting from a significant standard deduction. If the entire withdrawal could be placed in the standard deduction (such as if the kid is married and not withdrawing a full 4% of the account to start), then the IRR could be as high as 9.95% depending on state income tax. If the withdrawal is taxed at 17% (say using 12% federal bracket and a 5% state rate), the IRR drops to 9.63%. If the withdrawal is taxed at 27% (using 22% federal and 5% state rates), the IRR drops to 9.37%. Both the 17% tax (12% federal) and 27% tax (12% federal) IRRs of 9.63% and 9.37% (respectively) compare to taxable account IRRs of 9.7% (tax drag, 5% LTCG, 0% federal) and 9.38% (tax drag, 20% LTCG, 15% federal). To my mind the most plausible scenarios are 5% LTCG (state only) with an IRR of 9.7% vs. IRR of 9.74% using an effective rate of 12% (federal and state with SD) on 530A.
For the third 530A scenario, I estimated an effective tax liability of about 5.7% of a withdrawal and an IRR of 9.88%. If the withdrawal is taxed at higher rates, it could be 9.82% (12% federal, 5% state) or as low as 9.74% (22% federal, 5% state), although these are rough approximations. You can see how splitting the basis out into a Roth account at a young age will do better than just leaving it in for future taxable income to grow. This scenario sits in between the Roth conversion IRR figures and the figures for just leaving all the basis in the IRA.
Limitations
Of course, if any of this happens in a state with no income tax, then all sets of IRRs would go up since state income tax is modestly impacting dividend tax drag and LTCG as well as Roth conversions.
Also note a couple other things. I used a 10% gross return on these to accentuate the tax impact with heavy compounding. Using lower returns would tend to favor the 530A.
I used a dividend tax drag rate of 20 bps in taxable account scenarios. This might be a big assumption if the account would be held by a taxpayer with 0% LTCG space for a material period. For example, a UTMA/UGMA account might have no tax drag for the first 10-15 years while the balance is under $200,000 and dividends fall under the kiddie tax threshold of $2,700. That's one reason I included the version with no dividend tax drag as an upper bound.
All of my scenarios assume the current tax structure continues to apply. Congress may and likely will change the U.S. income tax regime in a variety of ways over 50 years, which will likely include effects on 530A accounts, IRAs generally, or taxable brokerage accounts. "Permanently" lower rates for qualified dividends and long-term capital gains are less than 15 years old, and 530A accounts are less than 2 years old.
I did not model inflation into the $5000/year contributions to 530A accounts. I do not think it would make a significant difference in the outcomes since any increase in basis in these accounts would tend to also mean higher basis in the taxable brokerage accounts.
I did not study realizing capital gains during 0% years. This should be available to a kid who gains control of a UTMA/UGMA and would otherwise have been able to conduct Roth conversions with a 530A account. Particularly if the kid is a resident of a no-income-tax state during college, this increase in basis could improve outcomes on the taxable side marginally.
Conclusions
The upshot is that 530A treatment vs. taxable brokerage account treatment is very close and could plausibly go either way based on a range of factors. The best outcome for the 530A account is if you can really pull off getting a significant amount of conversions in the standard deduction, but this will be complicated if the kid remains a dependent for tax purposes or has work income.
On the other hand--and I was surprised by this outcome--just not doing the Roth conversions at all can still land the kid in a pretty great place for eventual retirement income. Being free of dividend tax drag for 55 years and then withdrawing the money in the standard deduction and lower brackets is not actually bad even if not ideal.
Also, the whole thing is a stark reminder of the power of compound interest. Saving just $5,000 per year during a kid's childhood can plausibly provide for a kid's retirement if stocks maintain something like a 6.5% real aftertax CAGR.
To my mind the choice between using 530A and an alternative with taxable treatment comes down to a variety of other concerns:
530A is shielded from FAFSA, most taxable brokerage account ownership types are not
530A is legally under child's control at age 18, while some (but not all) taxable brokerage account ownership types may not be
530A is limited to U.S. stock indexes at this time until age 18, while taxable brokerage accounts can be diversified
530A accounts can shift asset allocation to bonds (and diversify to international) any time after age 18 with no tax consequences, while taxable brokerage accounts can't be rebalanced without considering tax consequences
530A accounts may have limited access until age 59 1/2 without significant adverse tax consequences, while traditional brokerage accounts have more flexibility withdrawal rules (though subject to LTCG tax)
530A's lack of dividend tax drag makes MAGI easier to control for FIRE parents and for kid across a lifecycle, although if Roth conversions are not performed, there could be a bigger tax headache later
530A accounts' limited contribution of $5000 may result in parents saving in more than one type of account, which could be a positive with respect to tax diversification and a negative due to complexity
530A accounts will require tracking basis (possibly even on tax returns), which may not be done automatically
530A will likely be shielded from creditors in most states, while taxable brokerage account structures will mostly be available to creditors unless placed in a specific type of trust
Best of luck!
EDIT: Ha, the last bullet point on considerations at the end was somehow up in the list of scenarios! Oops! I also added another bullet on the considerations.