When it comes to saving for a child’s college education, a 529 plan is one of the more popular options. A 529 plan is a state-sponsored investment vehicle designed to help parents and other adults fund a child’s future college costs. The account beneficiary is then able to make tax-free withdrawals to pay for eligible education expenses.
However, a 529 plan may not be right for you if you’re not sure how much money your child will need for college, or if you like to be more hands-on with your investments. Here’s what you should know about when to use — and when not to use — a 529 college savings plan.
How does a 529 plan work?
A 529 plan is a type of investment account that grows all money you contribute on a tax-deferred basis. Your earnings may be withdrawn tax-free as long as you use the funds for qualified educational expenses — such as tuition, fees, books and housing. If you start contributing to a 529 plan early, you could see sizable growth in your account by the time your child starts college.
You have many different options when it comes to opening a 529 plan. Most parents choose to open a 529 plan offered by their state, since some states offer tax deductions for contributions, but some parents will use another state’s 529 plan to take advantage of better investment options and lower fees.
Pros and cons of a 529 plan
While a 529 plan is one of the more well-known savings vehicles for college funds, there are benefits and drawbacks to consider.
- Account owners can receive a tax benefit. Currently, more than 30 states offer tax credits or deductions when you contribute to a 529 plan. The amount of the credit or deduction varies depending on the state.
- Earnings grow tax-free. The money in a 529 plan grows tax-free and can be withdrawn tax-free as long as you spend your earnings on qualified educational expenses.
- Beneficiaries can be changed. If you have multiple children and you don’t end up using all of a child’s 529 to pay for their education, you can change the beneficiary to another child. There is no fee or penalty to do this.
- Noneducational expenses may incur penalties. While contributions to a 529 plan can be withdrawn for any reason, earnings that are used for nonqualified expenses will be charged a 10 percent penalty, plus regular taxes.
- Some plans have high fees. There’s no federal regulation on 529 plans, and some state plans charge high fees that can eat away at your earnings.
- Investment choices may be limited. Each 529 plan sets its own investment options. Some plans are more limited than others, meaning there may be fewer ways to customize your investment.
When is a 529 plan a bad idea?
A 529 plan is a good choice for many parents. However, because 529 plans are fairly restrictive in terms of how you can invest — and use — your money, some parents may want to consider a different option.
You may want to consider an alternative to a 529 plan if:
- You live in a state where you won’t receive a tax credit or deduction for 529 plan contributions.
- You’re not sure if your child will attend college.
- You’re not sure how much money you’ll need to save for college.
- You have investment experience and prefer to choose from a wide range of investment options.
Alternatives to 529 plans
If a 529 plan isn’t the right choice for you, there are several alternative options to consider.
A brokerage account is an investment account where you can contribute money and invest it in the stock market. When you withdraw funds, you will owe capital gains taxes on any profits, though you can use funds for any purpose — not just an education.
Unlike with a 529 plan, there are no tax credits or deductions available for brokerage accounts. Brokerage accounts are also far more likely to impact your child’s eligibility for financial aid.
A Roth IRA is a type of retirement account that uses after-tax dollars, meaning you can withdraw contributions at any time without facing fees or penalties, and earnings may be withdrawn without penalty if used for education expenses. The benefit of saving for an education in a Roth IRA versus a 529 plan is that you aren’t required to use the funds for an education, so it’s a good option if you’re not sure how much money your child will need.
However, a Roth IRA isn’t designed for college savings; it’s a retirement account, so any money you withdraw to pay college costs will eat into your retirement savings. Taking distributions may also hurt your child’s chances for financial aid.
A custodial account is a savings plan that allows a minor to take ownership upon reaching adult age — either 18 or 21, depending on the individual state’s rules. You can withdraw funds anytime as long as they are for the designated child’s benefit. When the child reaches adult age, they can withdraw funds for any purpose.
There are also some tax advantages to custodial accounts; earnings on the account are tax deductible up to a point, and from there they are taxed partially at the adult’s tax rate and partially at the child’s tax rate.