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Saving for College? 3 Great Alternatives to a 529

By Maurie Backman - Updated Oct 12, 2018 at 3:01PM

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While 529 plans have certain benefits, these options might serve you better.

With higher education costs going nowhere but up, many families are doing their best to make college savings a priority. For years, 529 plans have been touted as a college saver's dream. Though the money you put into a 529 isn't tax-free, you can grow that money in a tax-free fashion until you're ready to withdraw it and start paying those hefty tuition bills.

But there's a reason why 97% of people don't open 529 plans to save for college. Despite the tax benefits, 529s come with a few major drawbacks -- namely, the fact that if you fail to use all the money in your 529 for qualified higher education purposes, you'll be dinged with a 10% penalty on your investment gains. Plus, some plans come with high fees that eat away at those coveted returns. If you're not sold on the idea of a 529, here are three different options to consider.

Graduates lined up

Image source: Getty Images.

1. Roth IRA
We all know that a Roth IRA is a great retirement savings vehicle, but did you know you could use a Roth to pay for college? It's true. If you withdraw money from a Roth IRA to pay for qualified higher education expenses, you won't incur penalties even if you take out that money before you reach age 59-1/2. Furthermore, you won't have to pay taxes on your contributions since they're not tax-deferred to begin with; you'll only pay taxes on your earnings. Better yet, wait till you're 59-1/2 to withdraw that money for college, and you won't pay taxes on your contributions or your earnings.

Now you won't get any up-front tax benefits by going this route, but you'd be in the same boat with a 529, as contributions aren't tax-deferred there either. And while both allow your money to grow in a tax-deferred fashion, with a Roth IRA, you've got more flexibility as to how you can use that money. If, for example, you open a Roth IRA with the sole intention of using it to pay for college and you wind up overfunding it, you can still withdraw that money tax- and penalty-free once you reach 59-1/2. With a 529, any excess funds you have will be subject to a 10% penalty on your earnings if they're not used for qualified education purposes. Additionally, unlike 529s, Roth IRAs aren't counted as assets on the Free Application for Federal Student Aid (FAFSA), which means yours won't limit your ability to score some financial aid.

2. Municipal bonds
If the appeal of the 529 lies in the opportunity to grow your money without being taxed on your gains, you may want to consider municipal bonds instead. Municipal bonds offer similar tax benefits in that interest earned is exempt at the federal level. And if you invest in a municipal bond issued by your state of residence, you can avoid paying state and local taxes as well. Unlike 529s, however, the proceeds from municipal bonds can be used however you see fit. You can use your earnings to pay for college, a home, or a giant vat of stuffed bunnies for all the government cares. In other words, that money is yours to use as you see fit, which means if your college costs wind up coming in lower than expected, you won't be penalized for saving too much.

3. Taxable brokerage account
Most 529 plans offer limited investment options, which wouldn't be a bad thing if they were known for their stellar performance. But according to investment research firm Morningstar, traditional mutual funds tend to outperform 529 plans. Furthermore, you're only allowed to make one investment change within a 529 plan per year. Talk about getting locked in. If you're the type who prefers to have more control over your investments, a traditional brokerage account earmarked for college might better serve your needs. While you'll lose the tax advantages of a 529, you'll have no limitations on investment choices or the frequency at which you make them. Play your cards right, and that could translate into lower-cost investments (think index funds and ETFs) coupled with a higher overall return.

While 529s are often an easy, convenient way to accrue some college savings, they're only one of many avenues you could take on the road to financing an education. But regardless of what vehicle you choose, the key is to start as early as possible to give your contributions years to grow. After all, college costs aren't showing signs of deflating any time soon, and if you're hoping to make a dent in that massive tuition bill, you'll need as much time on your side as you can get.

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