Parental income and savings are the largest funding source for college expenses. 529 education savings plans are often used for college savings—but they aren’t as common as you think. College savings funds only covered 30% of the average cost of attendance in 2023.
If you’re looking for other ways to save for college, you may consider a 529 plan or an alternative.
How Does a 529 Savings Plan Work?
There are two 529 plan options:
- Prepaid tuition. Families can prepay a child’s tuition at eligible public or private schools using current tuition rates. Most programs require you or your child to be a resident of the state you register in.
- College savings plan. A 529 college savings plan is an investment account that allows your contributions to grow tax-deferred. Your investments fluctuate based on market rates and performance. You can use funds for tuition, fees and housing for any college or university.
If you withdraw money for a non qualifying expense, you must pay income taxes and a 10% withdrawal fee. Eligible expenses include tuition, room and board, books, supplies and other school-required fees.
Pros and Cons of 529 Plans
529 plans are the most popular form of college savings accounts. However, you must understand the pros and cons before opening an account for your child or family member.
Pros
- Potential tax benefits. Your 529 contributions can grow tax-deferred, and withdrawals used for qualifying expenses are tax-free. Some states offer tax deductions or credits to families that contribute to 529 plans. For example, Alabama allows taxpayers to deduct up to $10,000. You can use the Education Commission of the State’s database to see if your state offers similar tax breaks.
- Value growth. A 529 plan functions like any other investment account. Your account may grow in value, depending on market performance and your investment choices.
- High contribution limits. 529 plans don’t have annual contribution limits, and maximum account balances can be $500,000 or more. Other college savings options, however, have low contribution limits. For example, the Coverdell Education Savings Plan has a $2,000 annual contribution limit.
- K-12 education use. Families can access their 529 to cover private K-12 tuition and withdraw up to $10,000 annually, per beneficiary without taxes or penalties.
Cons
- Limited investment options, Each state’s 529 plan has a pre-selected list of investment options, limiting your ability to choose your investments.
- Use limitations. Your contributions are tied to a beneficiary’s education. If that beneficiary doesn’t attend college or receives a full scholarship, the money must be switched to another beneficiary. Otherwise, non qualifying expenses will be subject to income taxes and penalties.
- Costly fees. Common fees include enrollment fees, maintenance fees, sales charges and management fees. These costs can impact your account’s earnings when combined with underlying fund expenses, such as mutual fund fees.
- Potential loss. As with most investment accounts, 529 plans have the potential for losses. There’s no guarantee that your investments will perform well and your account value may drop.
5 Alternatives to a 529 Plan
If you decide against a 529 plan or want something to have alongside one, consider an alternative.
1. Roth IRA
Roth IRAs are an investment account for many purposes, including college savings. You contribute post-tax dollars, making withdrawals during retirement tax-free.
While you can withdraw your contributions without paying penalties or taxes before you turn 59 and a half, withdrawals of your earnings are subject to taxes and penalties. Roth IRAs allow account holders to take distributions for qualified education expenses without the 10% penalty.
Roth IRAs limit how much you contribute per year. The maximum contribution amount is $7,500 for 2023. Roth IRAs also restrict people who make at least $153,000 individually (or $228,000 if married and filing jointly) from contributing.
2. Brokerage Account
A taxable brokerage account lacks the tax benefits of 529 plans or Roth IRAs. However, it allows you to invest your money in stocks, bonds, mutual funds or real estate investment trusts. You can withdraw money without worrying about penalties. However, you’ll pay capital gains taxes on the earnings.
3. Coverdell Education Savings Account
With a Coverdell ESA, you can invest in a child’s college education with tax-free investment growth and withdrawals for eligible education expenses. It can also cover qualifying elementary and secondary education expenses.
The maximum contribution limit is $2,000 per year per beneficiary.
4. Uniform Gifts to Minors Act (UGMA) or Uniform Transfer to Minor Act (UTMA) Accounts
UGMA/UTMA accounts are custodial accounts designed to hold gifts or transfers for a minor. The minor owns the account, but a custodian manages it until the minor reaches the age of majority—between 18 and 25 years old.
These accounts don’t have annual or lifetime contribution limits. And there is no penalty if the money isn’t used for college or education expenses. Once the minor reaches the age of majority, they can use the funds however they like.
However, UGMA/UTMA contributions can affect a minor’s financial aid eligibility and the funds cannot be transferred.
5. High-Yield Savings Account
If your child is close to pursuing a degree, an investment account may be too risky due to market fluctuation.
A high-yield savings account will typically produce less growth than investment accounts—without the risk of losing money. Compare the best high-yield savings accounts that have annual percentage yields (APYs) to find the best offers.
More From Advisor
- How To Lower Your Student Loan Payments
- Student Loan Refinance Rates: August 22, 2023—10-Year Loan Rates Move Down
- How To Pay Off $50,000 In Student Loans
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
