A 529 plan can be an excellent way to save for a child’s college education. Many states provide tax benefits for people who use one, and you can take advantage of more tax benefits as the balance grows and your child uses the funds for eligible expenses.
But there’s no one-size-fits-all approach to saving for college, and there are some potential drawbacks, including penalties if you use the money for other reasons and issues with financial aid eligibility, that could make a 529 plan less appealing for some.
What is a 529 plan and how does it work?
A 529 plan is a tax-advantaged savings account that can be used to save and pay for eligible college expenses. There are actually two types of 529 plans: prepaid tuition plans and college savings plans. But the latter is more common, so we’ll focus on that one.
With a 529 plan, you can make contributions, which grow tax-free. Then once your child starts taking withdrawals to pay for eligible expenses, there are no taxes on those distributions.
In addition to these tax benefits, some states also offer tax deductions or credits to taxpayers who make contributions. That said, you’re not required to use your state’s plan, and it may be beneficial not to if your state doesn’t offer any tax breaks.
Once you’ve contributed to a 529 plan, you can invest the money in mutual funds, which can help you grow the money over time. As a result, the earlier in your child’s life that you start saving, the higher the earnings potential.
What are the drawbacks of a 529 plan?
There are plenty of perks that come with saving for college with a 529 plan. But there are also some downsides that may cause some parents to look elsewhere.
For starters, the tax benefits only work if you use the funds for qualified educational expenses. That includes tuition, fees, books, supplies, equipment and, in some cases, room and board. If you or your child uses the money for anything else, it’ll be subject to income taxes, in addition to a 10 percent penalty.
If your child obtains a scholarship, you can withdraw the money without incurring the penalty. However, the funds will still be subject to income taxes.
You also don’t get much control over where you invest your money — investment options are determined by the state that offers the plan — and some states charge relatively high fees.
Finally, having a 529 plan could reduce your child’s eligibility for financial aid. While there are some changes being made to how the Department of Education calculates financial aid, particularly Pell Grants, your family’s finances are considered, and a robust 529 plan could make it harder for your child to get the better forms of aid that are available.
Other ways to save for college
Whether you’re on the fence about a 529 plan or you’re sure that you don’t want to use one, there are some alternatives to 529 plans that could work for your situation and goals.
A Roth IRA is an individual retirement account, but it can also be used to save for college. With a Roth IRA, you can save up to $6,000 in 2021, or up to $7,000 if you’re age 50 or older. Those contributions can grow tax-free, and you can take withdrawals up to the amount you’ve contributed without any taxes or penalties.
Once your child is in school, you can take withdrawals without the 10 percent early withdrawal penalty, but they will be subject to income taxes unless you’re at least 59 ½ years old. What’s more, your Roth IRA balance won’t count against your child when it comes to financial aid eligibility — though withdrawals will be considered income for that purpose.
- Your contributions grow tax-free.
- You can withdraw your contributions at any time free of taxes and penalties.
- Withdrawals for qualified education expenses won’t incur a penalty.
- Once you reach age 59 ½, all withdrawals are tax- and penalty-free.
- Withdrawals before age 59 ½ will be considered taxable and will count against your student when determining their eligibility for financial aid.
- There are no state income tax benefits for Roth IRA contributions.
- The allowed annual contribution is limited.
- Using a Roth IRA for college savings undercuts your efforts to save for retirement.
How to get a Roth IRA
You can open a Roth IRA with any brokerage firm that offers them. Once you open the account, you can start making contributions and invest the money based on the offerings available. Take your time to shop around and compare brokers before you open an account, though. Many features, including fees and investment options, can vary from broker to broker.
Education tax credits
The U.S. tax code offers two tax credits for students and families with qualified education expenses. The American Opportunity Credit (AOC) grants families a credit of 100 percent of the first $2,000 spent on tuition, fees and course materials, plus 25 percent of the next $2,000 per student for up to four years.
The Lifetime Learning Credit (LLC) allows a deduction of 20 percent for up to $10,000 of college expenses. Note, however, that you can’t use both simultaneously. Also, there are some limitations based on income and, for the AOC, the number of years your child is in school.
- If you didn’t have time to save in advance, the tax credits can alleviate the sting of paying for college.
- A portion of the AOC is refundable, which means that you can get the money even if you receive a tax refund.
- You can’t use education tax credits to save for college.
- If you have a 529 plan, you can’t double dip on tax benefits with an education tax credit.
- The LLC is not a refundable credit, which means you may not benefit much from it.
How to get education tax credits
When you file your tax return for the previous year, you can enter how much money you spent on qualified education expenses. Based on how much you spent, the credit you’re applying for, your income and other factors, you’ll receive some or all of the maximum credit that’s available.
Keep in mind, though, that if your child files their own tax return and you don’t claim them as a dependent on yours, they can apply for one of the education tax credits, but you can’t. If you do include them as a dependent, though, you can receive the credit.
Permanent whole or universal life insurance may not seem like a conventional way to save for college, but it is used by some parents. With one of these policies, you’ll have a cash value account in addition to the death benefit. That cash value grows tax-deferred at a relatively low but guaranteed rate.
A life insurance policy also won’t count against your child in the financial aid discussion. But permanent life insurance can be expensive, and in some cases, it can take up to 20 years to yield a strong-enough return to make it worthwhile.
- Life insurance provides a way to save on a tax-deferred basis, while also protecting loved ones in case the insured dies.
- Life insurance companies offer guaranteed growth.
- The cash value balance won’t be included in the financial aid discussion.
- Permanent life insurance can be cost-prohibitive.
- Some policies have surrender charges that penalize you if you withdraw money too early.
- While guaranteed, the return on a life insurance policy is low compared with other investments.
How to get life insurance
You can purchase a permanent life insurance policy from a licensed life insurance agent. Before signing on, though, have your financial advisor run some numbers on how much the life insurance policy will grow before your child heads off to school. Then compare those figures to the average return rate for your state’s 529 plan or other college savings options.
If you’re using tax-advantaged accounts for other purposes or you simply don’t want to tie up your college savings in an account with limitations and restrictions, consider investing with a brokerage account. These accounts won’t give you any tax breaks, but they can give you more control over your investments.
- A brokerage account gives you more power over investment choices.
- There are no limitations or penalties based on how you use the funds.
- There are no tax benefits.
- You have no incentive to hold onto the money for college expenses.
How to get a brokerage account
You can open a brokerage account with any broker. As with other options, take your time to compare multiple brokerage options to find the best fit for you based on your investment goals.
The bottom line
For some, a 529 plan can be the best way to save for their child’s college education. But it’s not a perfect option, and many parents may want to consider other ways to save for college before settling on their education savings strategy.
Take some time to research 529 plans and the benefits you can enjoy, as well as the drawbacks that could impact you. Also, compare them to 529 plan alternatives to make sure that you get the best fit for you.