With the cost of college continuing to rise, the idea of paying for those four years of tuition can be a major source of stress for a lot of parents. But the sooner you start saving for education expenses, the easier it might be to cover them.
Now, when it comes to saving for education, you have choices. You could buy a bunch of stocks or ETFs in a regular brokerage account and earmark those assets for your kids' education. Or you could invest in a 529 plan.
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The latter option is a good choice from a tax standpoint, but it may not be your best option overall.
Weighing tax benefits against flexibility
Investment gains in a regular brokerage account are taxable year after year. With a 529 plan, you won't pay taxes on investment gains or withdrawals, provided that money is used for education purposes.
And you're not just limited to college with a 529 plan. You can use that money to send your children to a private elementary, middle, or high school, should you so choose.
But while a 529 plan might seem like the better education savings plan from a tax perspective, you should know that if you end up taking a withdrawal for noneducation purposes, you'll face a 10% penalty on the gains portion of it, plus taxes on that sum. So if you want more flexibility with your money, investing in the stock market outside a 529 plan could be a better bet.
Remember, you can research college costs all you want and try to figure out what your kids' education will amount to. But that doesn't account for the many wild card factors that could come into play along the way.
What if one of your kids opts out of college completely? What if all of your children choose in-state public schools instead of private ones?
It can be argued that having excess funds in a 529 plan is a good problem to have. But it's a problem nonetheless.
When you buy stocks in a regular brokerage account, there's no such thing as an excess balance. You're not restricted in how you use that money, so you can give it to your kids to help them buy homes if they don't end up needing it for college. Or you can take it and use it to help boost your retirement savings -- something that may have fallen by the wayside so you could focus on your kids' education.
Another option to consider
While 529 plans are a useful tool in the context of saving for education expenses, the restrictions at hand negate some of that benefit. But a regular brokerage account won't give you any tax benefit at all.
As such, you may want to look at a third option for saving for college: a Roth IRA. Investment gains and withdrawals are tax-free in a Roth IRA, and there are no penalties for taking withdrawals for higher education. And if you end up with extra money in one of these accounts, it can simply become a retirement nest egg, which is another important thing to have.
