If you want to save for college, you likely know that you should save your money in a 529 plan.
A 529 college savings plan is a tax-advantaged account where you can save and invest money for future college tuition and qualified costs.
A 529 plan is the go-to answer for questions about how to save for college. But is it the best choice? It’s important to evaluate your options and explore alternatives before deciding what vehicle you’ll use to help pay for college when the time comes.
What’s wrong with a 529 plan?
There are a lot of great benefits to using a 529 plan to save for college. If you want to save your money in an account designed to help families create a financial plan to cover college costs, this option may be for you .
You can also make the most of this saved money because funds in a 529 are exempt from federal taxes. But, these plans also come with a few major disadvantages.
“The biggest downside to using 529s are that you have to use them for qualifying higher education expenses in order to get the tax advantages,” explains Stephen Alred, financial planner and founder of Ignite Financial.
“If your children don’t go to a higher education institution, you may have to transfer [the money] to another family member or eat the taxes,” Alred adds.
Alan Moore, a certified financial planner, and co-founder of XY Planning Network agrees.
“Funds in a 529 must be used for college,” Moore says. “Private secondary schools aren’t an option like they are for some other savings vehicles.”
If the intended recipient of all those colleges savings doesn’t go to college? Taking cash out and not using it for qualified college expenses means you’ll need to pay taxes and a 10% fee on any earnings.
529 college savings plan pitfalls
Even if the child you want to help does choose to pursue college, 529 funds count towards that child’s assets and EFC calculation for financial aid. This could prevent students from receiving need-based aid.
Feeling overwhelmed and confused? Trying to find help understanding 529 plans is also a major issue.
“Advisors cannot assist with managing 529 plans, so you are most likely on your own in figuring out how to invest that money once you open the account,” explains Moore.
That’s a problem because the investment options within the plans can be extremely limited and come with high fees. Without a professional who can help guide you, understanding the right financial moves to make is tricky. And mistakes can cost you money.
With all the downsides, it makes sense to ask about alternatives to 529 plans. The good news is that these plans are not the only options for college savers.
529 plan alternatives
“I’ve seen a plethora of ways to fund college expenses,” Alred says. “Some of them include using an HELOC, using the cash value within permanent life insurance policies, Roth IRA, prepaid tuition programs, UTMAs, UGMAs, among others.”
Ultimately, Alred says, “You can get really creative if you work a with college funding expert.”
Here are three of the most common alternatives you can use for your own college saving plan.
1. Using other savings accounts
529 plans are great because they allow you to invest your savings. That gives you the opportunity to earn a much better return on your money than if you were simply sticking cash in a savings account.
“Make sure you know how any decision to fund higher education expenses will affect all of your financial goals in the long-term before looking outside of 529s,” cautions Alred.
Savings accounts aren’t a good long-term option because the interest rates are so low. Your money will struggle to keep up with inflation — meaning that your savings could be worth less in 18 years than they are today.
Certificate of deposits, or CDs, provide a little bit more of a return but not much. For the best bet, you need to find another way to invest your money.
There are two ways you can put away money for college and invest it for a potentially larger return.
2. Roth IRAs
The first option is to utilize an account intended for retirement: a Roth IRA.
Roth IRAs are individual retirement accounts that allow people to save and invest after-tax money. You can withdraw any of your funds without penalty after age 59-and-a-half. You can also withdraw your contributions to your Roth IRA without penalty any time.
If you decide to withdraw your investment earnings before age 59-and-a-half you will be penalized, unless it’s for a qualifying reason. The good news is paying for college expenses for you, a spouse, your children or grandchildren is a qualifying reason, making Roth IRAs alternative college savings plans.
However, at the end of the day, Roth IRAs are designed for retirement. They come with some rules and regulations that are intended to help people save for retirement and to keep their money in their accounts until retirement.
Roth IRAs also come with contribution limits. You can only contribute up to $5,500 per year to your Roth IRA if you’re under the age of 50 and $6,500 if you’re older.
3. Brokerage accounts
Your second option is to utilize a simple brokerage account to save for college. Brokerage accounts are much like savings accounts in that you can deposit and withdraw money at any time without penalty.
Brokerage accounts give you access to any investment that you’d like to buy or sell. These can range from stocks and mutual funds to bonds, currency, and futures.
You can open a brokerage account through a broker. The options and what you can purchase will vary depending on the company you choose to open the account with.
There are no tax advantages associated with brokerage accounts. You’ll also be responsible for capital gains taxes if your money earns a return.
When choosing a brokerage account, watch for the fees associated with the product. There can be management fees on the account itself. And, depending on what you invest in, you may incur commission fees, too.
Many brokerage accounts also require minimum investments to open them, so you may need to save up your cash first before investing in one.
Evaluate your options for saving outside a 529 plan
There are a lot of options for college savings. Whether you choose the traditional 529 plan or explore alternatives like brokerage accounts, CDs, Roth IRAs, or other savings vehicles, you should understand the rules with the account you use.
Personal finance is personal, and using a certain account to save for college may make sense depending on your specific situation. If you decide to go outside of a 529 plan, consider talking to a fee-only financial advisor who can explain the pros and cons of any option you consider.
Ultimately, your best bet is to avoid regular savings accounts and CDs because the interest rates are so low. You can put your money to work and potentially earn a return by investing your savings instead.
If you’re saving for a child’s education and have a timeframe of five to 18 years before those funds are needed for college, investing in a 529, Roth IRA, or regular brokerage account can help you maximize the cash you set aside for those future expenses.
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