A 529 plan is a tax-advantaged savings plan used to pay for college expenses. Many states provide tax benefits for people who use one, and you can take advantage of more tax benefits as the balance grows and the funds go toward eligible expenses.

However, 529 plans also have potential downsides, including penalties if you use the money for other reasons and issues with financial aid eligibility. These drawbacks may make a 529 less appealing for some. If so, you may want to investigate alternatives to 529 plans.

1. Roth IRA

A Roth IRA is an individual retirement account that can also be used to save for college. In 2022, the annual limit for a Roth IRA is $6,500 for those under 50 years of age and $7,500 for those aged 50 or older. Those contributions can grow tax-free, and you can withdraw up to the amount you’ve contributed without any taxes or penalties.

Unlike a 529 plan, money in a Roth IRA won’t count against financial aid eligibility.

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 and a half years old. Using a Roth IRA for college savings could undercut your retirement savings efforts.

How to get started:
You can open a Roth IRA with any brokerage firm that offers them, but it’s important to take your time shopping around and comparing brokers before opening an account. Many features, including fees and investment options, vary from broker to broker.

2. Education tax credits

The U.S. tax code offers two tax credits for students and families with qualified education expenses.

The American Opportunity Tax Credit 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. A portion of the AOTC is refundable, which means you can get the money even if you receive a tax refund.

The AOTC has an income limit. In 2023, the income limit is a modified adjusted gross income of $80,000 for single filers or $160,000 for married couples filing jointly.

The lifetime learning credit allows a deduction of 20 percent for up to $10,000 of college expenses. The LLC is not a refundable credit, which means you may not benefit much from it if you receive a tax refund.

As of tax year 2022, the amount of the LLC available is gradually reduced if your MAGI is between $80,000 and $90,000 for single filers and $160,000 to $180,000 for those who file jointly. Individuals who earn $90,000 or more and joint filers earning $180,000 or more cannot claim the credit.

Note that you can’t use both education tax credits simultaneously, and you can’t use them to save for college.

How to get started:
When you file your tax return for the previous year, you can enter how much you spent on qualified education expenses. Based on your spending, the credit you’re applying for, your income and other factors, you’ll receive some or all of the credit available. This only works if the student is you, your spouse or a dependent.

3. Brokerage account

If you’re using tax-advantaged accounts for other purposes or 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 can give you more control over your investments.

There are no limitations or penalties on using the funds. You’re not restricted to using this money just for education-related expenses, so if college isn’t in the cards, this money can help them with expenses like buying a home or starting a business.

How to get started:
You can open a brokerage account with any broker. Compare multiple brokers to find the best fit for your investment goals.

4. Life insurance

Permanent or universal life insurance isn’t a conventional way to save for college, but it works for some. With one of these policies, you’ll have a cash value account and the death benefit. That cash value grows tax-deferred at a relatively low but guaranteed rate.

A life insurance policy won’t count against students for financial aid. However, 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. Many policies have high fees that eat away at investment growth.

If your policy grows enough, you can essentially take a loan out against the cash balance of your life insurance policy to pay for educational expenses. This loan can affect the death benefit payout, so know your policy details before taking action. Individual policy return rates vary widely. Have a financial professional who isn’t selling you a policy review any documents to tell you if purchasing a policy is a good choice.

How to get started:
You can purchase a permanent life insurance policy from a licensed life insurance agent. Before signing on, have a financial advisor run the numbers on how much the life insurance policy will grow before your student heads off to school. Then, compare those figures to the average return rate for your state’s 529 plan or other college savings options.

5. Coverdell education savings accounts

A Coverdell education savings account is an account similar to a 529 plan with more flexibility on investments but stricter rules on contributions. You can only contribute up to $2,000 per child annually until they turn 18.

While a Coverdell ESA allows your account to grow tax free, there is no tax deduction for contributions. Distributions from a Coverdell ESA are tax-free for qualified K-12 and college educational expenses.

This account has income limits that a 529 plan doesn’t have. You can’t contribute to the account if your MAGI is over $110,000 if you’re a single filer or over $220,000 if you’re part of a married couple filing jointly. Contribution limits tighten if your MAGI is between $95,000 and $110,000 for single filers and between $190,000 and $220,000 for joint filers.

How to get started:
You can open a Coverdell ESA account at most brokerage firms and banks. Make sure that you meet the income limits and don’t contribute more than $2,000 per year.

Why consider alternatives to 529 plans?

While a 529 plan has many benefits, including being a tax-advantaged savings account, it may not be the right choice for everyone.

There are some limitations and restrictions with 529 plans. For instance, a 529 account can only be used for qualified education expenses. This can be challenging if the account beneficiary decides to take a different path in life that doesn’t involve college. There’s a 10 percent penalty if the money in a 529 account is spent on nonqualified expenses.

The funds in a 529 account can also impact the amount of need-based financial aid your child is eligible for. However, the impact is likely to be minimal. If a parent or a dependent child owns a 529 plan, the first $10,000 will not impact eligibility for need-based financial aid. However, any amount above $10,000 can reduce financial aid awards by as much as 5.64 percent of the 529 account’s value.

Another important factor to consider is that 529 plan contributions do not come with the benefit of providing a federal tax deduction, which may be an important factor for you.

Some 529 alternatives may offer more flexibility in how the funds can be used while also minimizing the impact on your child’s need-based financial aid. Some options may even offer notable tax benefits, such as the Roth IRA, the contributions for which can grow tax-free and withdrawals can be made with incurring taxes. The best college savings plans will offer a mix of flexibility and benefits to suit your family’s needs.

The bottom line

For some, a 529 plan can be the best way to save for a college education. But it’s not a perfect option, and many will want to consider other ways to save for college before settling on a strategy.

If you live in a state that gives you a state income tax deduction for 529 contributions and you’re already maximizing your other tax-deferred investments like a 401(k), IRA, and HSA, contributing to a 529 plan can reduce your tax burden and save for the future at the same time.

If you don’t qualify for a tax deduction for 529 contributions or aren’t maximizing other more tax-efficient investments, one of the options above may be a better choice.

Frequently asked questions

  • There is no limit on the types of college savings plans you can have. Specifically, you can have as many 529 plans as you want. In addition, the same child can be named the beneficiary for all of the 529 plans you open. You will increase your costs when opening multiple 529 plans, as there are administrative fees to be paid with each account.
  • The ramifications vary depending on what you do with the funds in a 529 account. Because the money is specifically for education costs, you’ll face penalties if it’s not used for this purpose. Any cash pulled out of the account and used for other things will likely be subject to income tax. There are also penalties on the earnings in the account when funds are used for unauthorized reasons.

    You can sidestep these types of penalties by changing the account beneficiary. This could include naming other children or even grandchildren as beneficiaries. There’s also no limit to how many times the beneficiary on a 529 plan can be changed.

    Another option is to use the money for other education costs including private tuition at K-12 schools or qualified apprenticeship programs.
  • Starting in 2024, it will be possible to roll the funds in a 529 plan into a Roth IRA. The Secure Act 2.0 made it possible to convert a 529 to a Roth IRA.

    Designated beneficiaries of 529 plans can convert a total of $35,000 over their lifetime to a Roth IRA from a 529 plan. There are some rules for taking this step, including the 529 plan being open for at least 15 years before a conversion takes place. In addition, conversions must not exceed annual Roth IRA contribution limits set by the IRS.