But the plans also have downsides, which may help to explain why only 13 percent of families used them to help pay for college last year, and took from their accounts a paltry average amount of $10,031, according to student loan giant Sallie Mae.
Before your family starts a 529 plan, consider these drawbacks.
1. You may not like your choices
With a 529 plan, you put in after-tax dollars, your contributions are invested, and the money can be withdrawn tax-free when it’s used for tuition or other college-related expenses.
States generally sponsor their own plans, and more than 30 offer some kind of deduction on state taxes for 529 plan contributions.
But note that you are limited to the investment options that your plan makes available. So, you could be stuck with a poor selection of investments and high administrative fees and other costs.
2. Your investing window may be tight
Many plans offer an all-in-one fund that’s similar to a target-date fund. It’s designed to own more stocks when your child is young, and more bonds and cash equivalents, like money market mutual funds, when he or she nears college.
If you get a late start, you could find yourself stuck in a tight investing time frame.
Put off saving until your child leaves day care, for example, and you’ll have only about 13 years to build up a college fund.
Since you’ll need to get into asset-preservation mode six to seven years before the kid enters college, you’ll really have only about five years on the front end to pack your portfolio with higher-yielding stocks.
And you’ll pray that those aren’t down years for the market.
3. You might too easily trigger a penalty
Some would-be savers may be turned off by the requirement that 529 funds must be used for education. Take money out for any other purpose and you could incur a 10 percent penalty as well as an income tax bill.
Families who are somewhat more comfortable would do just as well saving in a normal, taxable investment account than in a 529 plan. That’s because households in the 15 percent income tax bracket don’t pay long-term capital gains taxes.
In other words, parents earning nearly $105,000 wouldn’t owe Uncle Sam a dime when selling part of their portfolio to pay for tuition for their children.
4. A Roth IRA may be a better option
Another alternative to consider is a Roth IRA. You’d contribute money after-tax and invest it through mutual funds, as with a 529.
But you’d be able to choose a brokerage, rather than settle for a state plan administrator.
You could withdraw your contributions without penalty, and older parents wouldn’t pay taxes at all after turning age 59 1/2.
Another positive: You could start saving much earlier. You have to wait to open a 529 plan until your kid has a Social Security number. But you could open and start to fund a Roth IRA in the year or two before you and your spouse start to think about children.
Higher earners wouldn’t qualify for a Roth IRA and would get more benefit from 529 tax savings.
What should you do?
So which is it: 529? Roth IRA?
The answer might just be: Yes.
Just as you diversify your assets, you also should diversify how you save for college, to give yourself some cover.
Use a 529 plan to guarantee some tax-free withdrawals, just in case your earnings might increase and push you into a higher tax bracket. But also fund a Roth IRA to hedge against your kid needing less money for college, and to be able to take more risk with your portfolio.
By spreading your savings around, you’ll give yourself the most financial flexibility for that day when your kid becomes a university freshman.