Paying for College? Explore These 529 Plan Alternatives
529 college savings plans are a popular way to save for college, with good reason. The money contributed to these accounts grows tax-deferred, and withdrawals are exempt from federal and most state taxes, as long as they’re used to pay for qualified education expenses, such as tuition, room and board, and fees. Many states also provide a tax deduction or credit for contributions to your state’s plan. Another benefit is that there’s no limit on the amount you can contribute to a 529 plan each year (although each state sets an aggregate contribution limit, those are usually quite high).
Given all the benefits, there are also drawbacks to 529 plans, including the following:
• 529 funds owned by an independent student with no dependents are counted at 20% for the purposes of determining the Student Aid Index (SAI). However, 529 funds owned by a dependent student or parent are counted at a maximum of 5.64%. 529 plans owned by grandparents and others aren’t counted. The higher the SAI, the less financial aid.
• Investment options within 529 plans can be very limited and often charge high fees.
• Funds must be used for qualified education expenses. If your child decides not to go to college and you use the funds for non-qualified expenses, you’ll be responsible for paying taxes on contributions when they’re withdrawn as well as a potential 10% penalty on any earnings withdrawn. However, starting in 2024, you have the option to roll over up to $35,000 of 529 plan assets to a Roth IRA for the beneficiary if the 529 plan has been open for 15 years (annual contribution limits still apply).
These restrictions are enough to give an investor pause, especially if they think their child has a chance of earning a meaningful scholarship or if they wonder whether their child will even attend college in the first place. Given the drawbacks, it may make sense to consider additional ways to save for a loved one’s college expenses. Following are several alternatives to 529s.
#1 – Coverdell Education Savings Accounts (ESAs)
A Coverdell ESA is a tax-advantaged savings account that allows you to contribute up to $2,000 per child per year until that child reaches age 18. The funds can be used to pay for qualified education expenses, including tuition, books and supplies, from elementary school through college.
One main benefit of a Coverdell ESA is the flexibility it offers, as funds aren’t reserved solely for college expenses. Another benefit is that this type of savings account offers a wider range of investment options than a 529. While many 529s limit investments to mutual funds, Coverdell ESAs typically allow an investor to also invest in individual stocks and bonds.
While Coverdell ESAs allow your funds to grow tax-free, there’s no tax deduction for contributions to an ESA. Another drawback is the relatively low income cap on these accounts. You can’t contribute to a Coverdell ESA if your modified adjusted gross income (MAGI) is more than $110,000 as an individual or $220,000 as a married couple filing jointly.
#2 – Pre-Paid Tuition Plans
A pre-paid tuition plan is technically a type of 529 but with a few differences. A pre-paid plan allows you to pay for your child’s future college tuition at today’s rates. Given the rapid increase in tuition rates over the last few years, this can add up to significant savings. While some states cap the total allowable balance you can have in your pre-paid tuition account, the limits are typically high, ranging between $235,000 to more than $500,000.
The main downside to these types of plans is that the tuition typically only applies to certain colleges within a particular state. In addition, the money generally can only be used for tuition and doesn’t cover other expenses such as room and board or fees. Still, it may make sense to consider a pre-paid tuition plan if your child knows for certain he or she will be attending an in-state school that’s covered by the plan.
#3 – Custodial Accounts
Uniform Gift to Minors Act (UGMA) and Uniform Transfer to Minors Act (UTMA) accounts are custodial accounts that allow parents to set aside money for their children’s benefit. Although they don’t provide the tax benefits of a 529 account, an advantage of these accounts is that they offer the account holder more flexibility to decide how the money is invested and how it’s eventually used.
The balance of these accounts is specifically set aside for the child’s benefit, but the assets don’t need to be used to pay for college. This freedom makes custodial accounts a good option for parents who want to help support their children after high school but are unsure whether they’ll attend college. Similar to a Coverdell ESA, the investment options within a UGMA or UTMA are extensive.
A downside to these accounts is that they aren’t tax advantaged like a 529. Contributions aren’t eligible for a deduction or credit, and the account’s earnings are taxable. It’s also important to note that these accounts count as your child’s assets, and up to 20% of the account balance can be considered in calculating your EFC on the Free Application for Federal Student Aid (FAFSA), which could have a negative impact on your child’s eligibility for need-based financial aid.
#4 – Roth IRAs
Although primarily intended as retirement savings vehicles, Roth IRAs can also be used to save for college. These accounts allow after-tax contributions to grow tax-free, and qualified distributions (including education expenses) are tax-exempt. There are no penalties for withdrawing contributions to the account because they were originally made with after-tax funds, and earnings are also exempt from early withdrawal penalties when used to pay for qualified education expenses.
An additional benefit is that Roth IRA contributions aren’t counted as an asset on the FAFSA; however, distributions must be included as untaxed income or taxed income if you’ve had the account for less than five years.
One major downside to using a Roth IRA to save for college is that your contributions are limited to $6,500 per year, or $7,000 if you’re age 50 or older (as of 2023). This means if you’re maxing out Roth IRA contributions to save for college, you may not be saving enough for your own retirement. It’s important to find the right balance between paying for college and saving for your future.
#5 – Investment Accounts
Maintaining a diversified investment portfolio has the potential to provide higher returns over the long term. Consider opening a taxable brokerage account and investing in low-cost index funds or exchange-traded funds (ETFs). Both investments offer the potential for investment returns with lower fees than typical mutual funds. These types of investments are also extremely tax efficient, offering long-term capital gains tax treatment on dividends and gains if held longer than a year. Any funds not used for college expenses can continue to grow for other financial goals, including retirement.
Keep in mind this approach comes with some risk, as the value of investments can fluctuate. If your child ends up starting college during a market downturn, you could end up locking in losses. However, stock market investments have historically provided higher returns than many other savings options. Your wealth advisor can review your risk tolerance and time horizon to help determine if it makes sense to save for college in an investment account and what allocation to use for your time horizon.
#6 – Real Estate
Investors comfortable with real estate may consider purchasing a rental property with the goal of providing income down the road that will supplement their child’s college expenses. It’s important to choose a property where the rental income would easily cover total expenses, including the monthly mortgage. If conservative assumptions on rental income growth are projected to be enough to help a family with tuition payments by the time college starts, then a reasonable downpayment on a rental property may be a perfectly appropriate way to consider saving for college. An advantage to this strategy is that once a child is done with college, the income continues on for the investor (and can be used to supplement retirement). Of course, being a landlord isn’t for everyone, and the risks involved with owning real estate should be carefully considered.
Could you use come guidance to determine what combination of college savings accounts is right for you? Creative Planning is here for you. Our teams specialize in helping clients make smart financial decisions. We take the time to get to know you and understand your specific needs before implementing custom strategies to help maximize your savings and work towards achieving your goals. To learn more, schedule a call with a member of our team.