There’s no single best way to save for college. The many 529 plans offer federal and sometimes state tax advantages. But they also lower a family’s financial aid eligibility, have restrictions on where money can be invested and are subject to market fluctuations.
They also come with penalties when beneficiaries decide not to attend college, attend unaccredited institutions or go to schools located outside the U.S.
Here are some 529 alternatives.
Offering federal (but no state) tax advantages and no penalty if the child decides not to attend college, Roth IRAs could be a better bet for low-income families who rely on financial aid.
One of the few savings vehicles that won’t count against families when determining aid eligibility, Roth IRAs allow each parent under the age of 50 to invest up to $5,000 per year ($6,000 for parents over age 50) to pay for any qualified educational expense at an accredited U.S. school without penalty.
Richard Joseph, a college funding adviser and owner of MVP College Funding LLC in North Andover, Mass., says Roth IRAs come with drawbacks beyond the yearly contribution cap.
“You can’t use any Roth IRA earnings for education,” he says. “Your college savings money won’t grow in a Roth.”
Darren Scrimpshire, a licensed financial adviser with Sapient Financial Group in San Antonio, says that Roth IRA funds aren’t calculated as an asset when financial aid is doled out but will count against families once they’ve started making withdrawals.
“Once funds are taken out of a Roth, you have to pay taxes on them, which could affect your (aid) for next year,” he says. “If you made $50,000 this year and withdraw $10,000, it looks like you made $60,000.”
To get the maximum financial aid, Joseph and Scrimpshire recommend taking out a loan for the first few years of college, deducting the interest on your taxes and using Roth IRA funds for the last year or two.
Education tax credits
Families that only save in a 529 plan can’t use those funds to obtain education tax credits, too. For low savers and those who have waited until the last minute to start saving, the credit can be more valuable than throwing small amounts into a 529 plan.
The IRS reports that families can currently cash in on two tax credits. For single filers with incomes less than $80,000 per year ($160,000 for joint filers), the American Opportunity Credit grants families credits of 100 percent of the first $2,000 spent on tuition, fees and course materials, and 25 percent of the next $2,000 per student for up to four years. For families that only have a few thousand saved for college and have waited until their child is in high school to invest it, the returns on a 529 aren’t likely to reach the same level of savings.
Ryan Himmel, a CPA and founder of BidaWiz.com, a website that connects consumers with financial experts, says that a 529 plan makes sense in states that offer a match for low-income households. Otherwise, “(families should) first apply the education credit to (college) expenses and then apply funds from a 529 plan for remaining costs,” he says.
The Lifetime Learning Credit allows a deduction of 20 percent for up to $10,000 of college expenses, but it can’t be used in conjunction with the American Opportunity Credit. Families can only claim one Lifetime Learning deduction per household, not per child, and have to shell out $10,000 to get the full benefit. So in some cases it makes more sense to stash those funds in a 529 plan instead, Joseph says.
“I recommend using permanent life insurance as a savings tool,” says Rodney Ballance, author of “The Love of Money” and host of the nationally syndicated radio show “Ballancing Your Budget.” “It grows tax-deferred, you get compound interest on it that doesn’t rely on the market and you can use it for college.”
Unlike 529 plans, funds stashed in a life insurance policy won’t count against a family’s financial aid award and policies have no yearly contribution caps, making them attractive to high earners who have maxed out other tax-deferred savings vehicles. Permanent whole life and universal life plans frequently come with guaranteed returns, so families will never lose funds.
According to the financial aid website Finaid.org, policy holders can make withdrawals for college costs but can only withdraw funds they’ve invested (not earnings) without paying penalties.
Life insurance policies aren’t a blanket solution. Costs vary tremendously from policy to policy, but Joseph says insurance can only work if families find a policy with commissions and fees comparable to those of their state’s 529 plan. Also, families need to be aware of how the policy works and of any surrender charges that could be incurred by withdrawing funds early, and be prepared to leave their funds in long enough to justify upfront costs.
Before signing on, have your financial adviser 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.