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, there’s no one-size-fits-all approach to saving for college. 529 plans come with potential downsides, 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 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. Withdrawals to pay for eligible expenses 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.

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 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 state 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 have 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
  • No federal tax deduction

5 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, these alternatives may work for your situation and goals.

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 $6,000 for those under 50 years of age and $7,000 for those aged 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.

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. Keep in mind that 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 2022 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.

In 2022, the LLC’s income limit is a MAGI of $69,000 for single filers and $138,000 for married couples filing jointly. Your LLC’s amount shrinks if your MAGI is between $59,000 and $69,000 for single filers and between $118,000 and $138,000 for married couples filing jointly. Above that, you can’t claim it.

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. Take your time comparing 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 in addition to 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. 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. 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 make sure you understand the risks. Individual policy return rates vary widely. Have a financial professional that 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.

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.

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