Many parents want to help their children get the best start in life — and for some that includes helping them, to some degree, with college. One way to save up for your child’s post-secondary education is with the help of a 529 plan. However, a 529 isn’t always the right move for every family.
As you consider how to save up for your child’s future, don’t forget to consider alternatives to 529s, as well as the plans themselves. Here’s what you need to know about the 529 and its alternatives.
What is a 529 plan?
An investment account for your educational expenses
A 529 plan is a special investment plan designed to help you save for qualified education costs. With a 529, you set money aside in an account and it grows tax-free — as long as it’s used for eligible expenses.
There are limits on what the money can be used for
While some states offer tax deductions for contributions made to a 529, it’s important to note that you won’t receive a federal tax break for your contributions.
Additionally, there are limits on what the money can be used for penalty-free. If you don’t use the money in a 529 for a qualified expense, you’ll end up paying taxes on the withdrawal, along with a penalty.
For some families, a 529 makes sense because it allows you to grow money in an efficient way. Investment choices often include index funds, so if the market does well, your child could benefit from the tidy amount involved. However, it’s also important to note that if the market drops just before you need the money, you might not have as much as you’d planned on to help your child pay for school.
You’ll face penalties if the money isn’t used for education
On top of that, if your child decides not to attend an eligible program, you’ll need to either name a new beneficiary for the account or accept the taxes and penalties on withdrawals. For some, the idea of all that uncertainty is enough to look for alternatives to 529s.
If you aren’t sure a 529 plan is the right approach for you, or if you want something else in addition to a 529, there are other options.
Here are some alternatives to 529 plans:
High-yield savings accounts
With a high yield savings account, you don’t have to worry about what the money is spent on. There are no restrictions on how the money is used and it will even grow while it is waiting to be spent.
On top of that, you don’t have to worry about market gyrations. Your principal is protected, no matter what happens.
Normally, you wouldn’t be able to tap into a Roth IRA until you reach age 59 ½. However, if you want to take advantage of the tax advantages of a Roth IRA, you can do so for education. Education is one of the ways you can access Roth IRA money early.
Additionally, with a Roth IRA, you can withdraw your contributions at any time without being subject to a penalty. This adds additional flexibility to your account. However, you do have to be careful not to dip into your earnings. If you do, be prepared to pay a penalty for non-approved purposes.
A Roth IRA offers a little more flexibility than a 529 while providing you with access to funds. You can open a Roth IRA with a robo-advisor like Wealthfront.
Wealthfront lets you set up a retirement account in just a few steps. You start by linking your financial accounts, which eliminates the need for all the pesky paperwork you’ll fill out for other companies.
Then Wealthfront will show you what your future could like with their recommended retirement accounts. For IRAs, you can choose to go with a Traditional or Roth IRA through Wealthfront.
Some 529 plans offer limited choices when it comes to investing, mostly focusing on index funds. If you want something a little more flexible, but still with tax benefits, a Coverdell ESA can be an option.
You can invest in almost any stock, bond or fund, and the earnings grow tax-free as long as you use them for qualified education expenses. With the Coverdell ESA, you have more options and still get the tax benefit.
There are some restrictions, however. You can only contribute up to $2,000 a year to a Coverdell ESA, and the beneficiary must withdraw all the money in the account by the time they are 30.
Taxable investment accounts
With a taxable investment account, you have total control over how you spend the money. You can grow the college fund rapidly, with the help of investing, without the restrictions that come with how you can spend the money.
If you go this route, however, it’s important to pay attention to when you sell your assets. You want to sell older assets first so that you can take advantage of the favorable long-term capital gains rate. You’ll have to pay taxes on your earnings, so it’s a good idea to plan for that.
» MORE: Here are a couple of the best investment accounts on the market today.
Prepaid tuition plans
Some states and colleges are starting to offer prepaid tuition plans. If you sign up for one, you can buy tuition credits at today’s prices. By buying these credits ahead of time, you can potentially save thousands of dollars over time, especially when you consider how quickly tuition can rise.
However, it’s important to understand that you might be limited as to where you can use the funds. If you get a prepaid tuition plan through a state, you can usually only use the balance to pay for specific in-state public schools. When you buy tuition credits at a specific school, you run the risk that your child won’t actually get into the school later.
If it works out, though, a prepaid tuition plan can be a smart way to pay for your child’s schooling in increments while saving thousands of dollars.
Due to the rising cost of college, you’re probably going to need to save up some money ahead of time to help your child pay for their higher education. If you want to reduce the amount of student debt they end up with, it can make sense to find a way to save up as much as possible.
A 529 plan can be a good tool for college savings, but don’t forget about other options that might work just as well — or even better.