Investing for College: 529 Plans and Alternatives

Investing for College: 529 Plans and Alternatives

A 529 plan is only one way to save for college. Consider using an IRA, Coverdell ESA, or UTMA custodial account for more flexibility.

Sep 7, 2021

Investing for College: 529 Plans and Alternatives
Investing for My Kids

Investing for My Kids

High Yield Savings

High Yield Savings

Beginners

Beginners

Lawyer, doctor, architect? Whatever your child or future children dream of being, they’re going to need a good education, and that costs money. Private college fees cost around $41,000 per year, while public college fees range between $11,000 and $27,000 per year depending on whether the student is a state resident or not. Plus, those fees don’t include room and board. 

Needless to say, paying out-of-pocket for higher education in the US is a pipe dream for most families—unless you plan ahead. It’s never too late to start saving for your child’s future, even if you don’t have kids yet. What’s the best way to do that? While 529 plans are a popular college savings option, there are others you should consider before making a decision. 

There are several alternatives to 529 plans; some of which have the potential to earn higher returns (with added risk) or give you more spending flexibility in case your child decides not to go to college. So, should you stick with the road most traveled or branch into 529 savings plan alternatives? Let’s find out.

What is a 529 savings plan and how does it work?

529 sounds like the name of a '90s R&B group or the title of an Ariana Grande track, but it's actually a financial tool that helps you save for someone else's college tuition. A 529 is a savings plan that’s aimed towards college education costs, apprenticeships, and K-12 education. 529 plans include those for savings and prepaid tuition. 

These types of savings plans are tax-advantaged, meaning you can deduct your contributions from your state income tax return (depending on the state you live in), and you won’t get taxed on any cash you withdraw as long as you spend the money on education. So, if you save $70k, growing it to $100k over several years, the extra $30k is yours without having to spend some on tax. 

For many people, a 529 plan can work in their favor. You can simply schedule automatic investments directly from your paycheck or bank account. Plus, you can save some serious cash, with the maximum overall limit in some states previously ranging from $230,000 to $525,000.

Is a 529 savings plan the right choice for me?

If you start saving early, then a 529 plan could be the best choice for you as your money has time to grow. The average return is between 3% to 5%, much more than a traditional savings account. 

Your saved money is also non-taxable from both income and federal taxes provided that it’s spent on college fees, room and board, books, electronic devices, food, and computers. Alternatively, you can save for trade school or vocational fees, such as a community college or graduate school. A 529 savings can’t be spent on any student loans, transport or medical costs, or sports and campus activities. 

Your contributions, however, are not exempt from taxes. More than 30 states offer tax deductions, but you’ll be required to invest in a state-managed plan. Some states will enable you to save as a non-resident, but you won't be entitled to a tax break. As an individual parent, you can add up to $15,000 each year to a 529 plan without having to pay federal gift taxes (that means if you’re married, you can jointly save $30,000). If you have the cash, you can add five years’ worth of contributions at the start of your plan. 

What happens if your child decides not to go to college? There’s a 10% penalty on your gains if your 529 plan is withdrawn for any other reason except death, scholarship, or US service academy enrollment. There’s no early withdrawal fee either as long as your child has qualified. If not, you’ll still have to pay the 10% penalty. 

A 529 plan will also impact financial aid. A parent’s plan is an asset, with the first $10k normally coming under the Asset Protection Allowance. The remaining amount will decrease financial aid by a maximum of 5.64% of the overall value.

Is there a better alternative to a 529 plan?

The 10% penalty on your gains can significantly impact you if you were to overfund your 529 plan. While an alternative may provide a better solution, you should understand the tax implications of these types of alternative investments. It’s also important that you know the best investing method for your personal situation. 

Still unsure what to do? Here are some alternatives to consider.

Individual Retirement Account (IRA)

Best for: Those who are making smaller contributions or are unsure if their child wants to go into further education.

ProsCons
  • Funds can be withdrawn early 
  • Tax-free growth
  • Not counted towards financial aid
  • Maximum contribution of $6k per year for under 50’s and $7k per year for over 50’s
  • You might have less cash for retirement
  • No upfront tax deduction on Roth IRA

A traditional IRA and Roth IRA can be used towards college education. What’s more, you can fund these alongside a 529 plan. However, using an IRA to save for college requires some more advanced financial knowledge to avoid unexpected taxes and penalties. Plus, there are limits to how much you can contribute to an IRA, and using that money to cover college tuition means sacrificing it as money you can use in retirement. This isn't always a wise choice, so make sure you weigh the consequences thoroughly.

That being said, the cash you save is more flexible in an IRA, because it doesn't have to be used for educational expenses. If your child decides not to go to college and you wait until retirement age (59 ½) to withdraw your funds, you can spend them on anything. If you want to withdraw them before retirement age, you can do that without penalty as long as the money is used for qualifying educational expenses. Otherwise, you may have to pay a 10% penalty and income tax on an early withdrawal.

There's also more flexibility when it comes to what you invest in. A self-directed IRA lets you invest in just about anything, including real estate, crypto, farmland, art, and more. While this can mean more risk, it can also lead to higher returns.

For example, you can use your self-directed IRA to invest in commercial real estate investment platforms like CrowdStreet, which aim for a target return of 9% to 24%. If you're able to achieve that, you'll beat most 529 plans by a significant margin.

crowdstreet

CrowdStreet

4.5

Real Estate

Coverdell Education Savings Account (ESA)

Best for: Adding extra savings on top of a 529 plan

ProsCons
  • Can be used for extra funding
  • Tax-free growth
  • Can be used for K-12 fees
  • $2k per year maximum contribution
  • Money must be used by the age of 30
  • Cash contributions only

An ESA is a trust/savings account that is designed to help families pay for education costs, including K-12 fees. A person can only contribute to an ESA when they earn $110,000 or less, or $220,000 on a joint tax return. 

A maximum of $2k can be contributed annually for any single beneficiary, while the funds must be distributed within 30 days of their 30th birthday. However, the savings can be transferred to a different relative. 

Any money deposited in an ESA can grow tax-free, and the distributions are free from tax as long as they are spent on education. Like a 529 plan, there is a 10% penalty on withdrawing your savings early, and it will be classed as taxable income. Similarly, up to 5.64% of the ESA value is considered when applying for financial aid at college.

A Coverdell ESA can also be self-directed, meaning you can invest in alternative assets like real estate and crypto. If you really know your virtual currency stuff, there are even crypto Coverdell ESAs. These accounts connect with crypto trading platforms like Gemini, which enables you to instantly purchase cryptocurrency with a minimum investment of $1. However, this method is riskier than investing in a traditional ESA account.

gemini

Gemini

Crypto

UTMA and UGMA accounts (custodial accounts)

Best for: Those wanting to reduce tax liability

ProsCons
  • Child’s rate of tax possible
  • Savings don’t have to be used on education
  • No maximum contributions
  • Potential of federal gift taxes
  • Counts towards financial aid
  • Child gets full control of account at 18 or 21

Custodial accounts in the form of Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA) enable an adult to open an account in a child’s name. As the savings are ‘owned’ by a minor, they are usually taxed at a child’s rate. Up to $1,100 is tax-free, the next $1,100 is liable for 10% tax, while anything over that is taxed at a parent’s rate. Adults contributing $15k or more may also be liable for federal gift taxes. 

Unlike a 529 plan, money invested can be used for non-education purposes, such as a car or house. Savings can only be withdrawn early if it’s in the interest of the beneficiary. It’s also important to understand that financial aid is diminished by 20% to 25% of the account's value.

You can invest in a variety of assets apart from stocks and bonds. You can begin saving easily with EarlyBird. This platform allows you to open a UGMA, gifting contributions for your child’s future. A portfolio can be created with your desired risk level, with money being grown via value and dividends.

earlybird

EarlyBird

Robo Advisor

So, what's the best college savings plan for me?

Here’s the less-than-satisfying answer: There’s no one-size-fits-all answer when it comes to saving for college. Your best option will depend on your income and your particular situation. 

While a 529 plan is a safe bet, you can add an extra layer of savings by opting for an alternative investment. If you’re unsure that college or further education is the right path for your child, you may want to investigate opening a custodial account or IRA. If you’re on a lower income, an ESA may be the best bet for you. Just make sure that you’re not using your retirement account or your dream of sipping a cocktail on a tropical island may be in jeopardy. 

It’s also important to think about the tax implications and risks associated with your investments. You don’t need to limit yourself to one type of account so consider all options before making a decision.

True or False:

When you contribute to a traditional IRA, you get to contribute income before taxes, but your contributions are taxed upon withdrawal. On the flip side, Roth IRA contributions are made after taxes, but they grow untaxed and aren't taxed upon withdrawal. This means you can withdraw your Roth IRA contributions early, for any purpose, and not pay the early withdrawal penalty.

True or False:

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