A 529 plan is a tax-advantaged savings plan used to pay for a child’s 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 your child uses the funds for eligible expenses.
However, there’s no one-size-fits-all approach to saving for college. There are some potential downsides to 529 plans, including penalties if you use the money for other reasons and issues with financial aid eligibility. These drawbacks could make a 529 plan less appealing for some.
What are 529 plans and how do they work?
A 529 plan is a tax-advantaged savings account that can be used to save and pay for eligible college expenses. The tax advantages associated with these savings accounts make them one of the most popular ways to save for a child’s education.
There are two types of 529 plans: prepaid tuition plans and college savings plans. The latter is more common, so we’ll focus on that one.
Contributions to a 529 plan grow tax-free. Once your child starts taking withdrawals to pay for eligible expenses, those distributions are not taxed either.
After 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 you start saving, the higher the earnings potential of your child’s account.
Is a 529 plan the best option?
Typically a 529 plan is the best option if you’re able to start saving early and you’re able to contribute a large amount. It’s not the best option if you’re saving at the last minute or you want more control over your investments.
Advantages of a 529 plan
Some of the biggest benefits of a 529 plan include:
- May be eligible for a tax deduction.
- Earnings grow tax-free.
- Funds can be used for tuition, books, supplies and room and board.
- High contribution limits.
Disadvantages of a 529 plan
529 plans do have some downsides. Some of the most important considerations are:
- Can only use the money for qualified education expenses.
- Comes with a 10 percent penalty if you use 529 funds for nonqualified expenses.
- Can have a small impact on financial aid availability.
- Limited control over where you invest your money.
4 best alternatives to 529 plans
Whether you’re on the fence about a 529 plan or certain that you don’t want to use one, there are some alternatives that could work for your situation and goals.
1. Roth IRA
A Roth IRA is an individual retirement account, but it can also be used to save for college. In 2021, the annual limit for a Roth IRA is $6,000 for those under 50 years of age and $7,000 for those 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. Also keep in mind that using a Roth IRA for your child 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, can 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 (AOTC) 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 lifetime learning credit (LLC) 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.
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 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 available. This only works if you claim your child as a dependent.
3. Brokerage account
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.
There are no limitations or penalties based on how you use the funds, but there are no tax benefits, either. You’re not restricted to using this money just for education-related expenses, so if your child decides not to go to college, 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. As with other options, take your time comparing multiple brokers to find the best fit for your investment goals.
4. Life insurance
Permanent 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 when it comes to financial aid. 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.
How to get started: You can purchase a permanent life insurance policy from a licensed life insurance agent. Before signing on, 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.
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 will want to consider other ways to save for college before settling on the right strategy.
Take some time to research 529 plans and the benefits you can enjoy, as well as the drawbacks that could impact you. Compare them to 529 plan alternatives to make sure you get the best fit for you.