Advocates of college savings plans have dubbed May 29 "529 Day," referring to the section of the Internal Revenue Code that authorizes the tax-favored accounts known as 529 plans.
But many parents don't realize that there are alternatives to 529 plans that can often produce even better results for those looking to make the most of their college savings. Looking at alternatives allows you to take a more holistic approach to your overall college-savings strategy.
Why 529s Aren't Your Only Choice
There's no dispute that 529 college savings plans are extremely useful as part of a successful strategy for building an investment portfolio to use toward paying your children's college costs. With key tax benefits like tax-free treatment for investment income that you use toward permitted college expenses and very high contribution limits, 529 plans offer advantages you won't find in other savings options.
But 529 plans aren't always the best move for every investor. With some 529 plans, limited investment options and high cost levels for mutual funds and other underlying investments make them less attractive as long-term savings vehicles, despite their tax advantages.
Consider the Alternatives
Parents have three reasonable choices beyond 529 plans to save for college:
1. Coverdell Education Savings Accounts
Coverdell Education Savings Accounts or ESAs give you a lot more flexibility to make exactly the investments you want toward your children's college education. Unlike 529 plans, Coverdell ESAs have almost no restrictions on what investments you can make, with brokerage accounts giving you access to a full selection of stocks, bonds, ETFs, mutual funds, and other types of investments. Yet ESAs share the favorable benefit with 529 plans that the income they produce is tax-free when you use it for educational expenses.
The challenge with Coverdell ESAs, though, is the low limit on contributions. Currently, the limit is just $2,000 annually, meaning that even if you're diligent about setting aside the maximum each year, it will only make a small dent in your child's financial needs for college.
2. Custodial Accounts
With a custodial account, you hold money as custodian for your child. Different states have different laws covering custodial accounts, but generally, you can open an account in a child's name and manage that money in whatever investments you want. The account gets treated as a regular taxable account for tax purposes, but the benefit is that income is attributed to your child's tax return rather than your own, often qualifying for advantageous tax rates at least for some of the income from the account.
Custodial accounts do come with two big challenges. The one that makes most parents uncomfortable is that you're legally obligated to give control of the account to your child at the age of majority, which is typically 21. In addition, financial aid treats custodial accounts as available for the child's contribution to educational expenses, which can lower the amount of outside support your child receives.
3. Keeping College Savings In Your Own Account
Finally, one simple thing many parents do is just to keep an investment account in their own names that they know is earmarked for their children's education. By doing so, they can keep managing their own investments the way they always have, sometimes taking advantage of cost savings from aggregating their assets in a single account.
The downside to this strategy is that income is fully taxable at your own usually higher tax rate. But because financial aid calculations treat parental savings more favorably than the child's own savings, holding onto your own money might actually be advantageous compared to a custodial account even with potentially higher tax liability.
The Right Mix for Your Kids
The best answer for most families involves a combination of these strategies.
- Finding low-cost 529 plans with index funds as a core portfolio can get you most of the way to your savings goals.
- Then, you can use the limited funds you're able to invest in a Coverdell ESA to make targeted investments in stocks that you're most confident about.
- Investing just enough in a custodial account to take advantage of your child's favorable low tax rates can limit any concerns about financial irresponsibility down the road.
- Finally, keeping some funds on hand in a regular brokerage account hedges against the possibility that you might need money for needs other than those that qualify for college-savings tax breaks.
529 plans are a great way to save for college, but they aren't the only answer. By using these alternatives instead of or as supplements to a 529 plan, you can get the best of all worlds in your college savings strategy.