College is more expensive than ever, and it takes foresight to prepare fully for the financial burden of paying for a college education. Students collectively have taken out about $1.2 trillion in outstanding student loan debt, and that overhang has financially crippled many graduates for years after they leave school.
Parents can help by saving toward their children's college costs, and many people -- including me -- use 529 plans to get some valuable tax benefits from college saving. Being able to save in a tax-favored account has a number of advantages, as Fool personal finance expert Maurie Backman notes in this article. Indeed, 529 plans were just expanded to offer tax benefits for savings toward pre-college educational costs as well. But there are a few problems with 529 plans that make incorporating alternative methods of saving for college look more attractive. Here are three reasons to consider going beyond 529 plans for your college savings.
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1. Limited investment options
The biggest reason why you might want to go beyond 529 plans is if you're an investor who wants to go beyond the limited investment choices that you have in 529s. Typically, you'll be limited to mutual funds, ETFs, and various bank products like certificates of deposit in a 529. That's fine for many people for whom a good index fund is enough to reach their financial goals. But if you want to invest in individual stocks, you'll be out of luck.
By contrast, some alternatives let you have much more flexibility in your savings. Coverdell Education Savings Accounts allow for full brokerage options, although one barrier there being a low $2,000 annual contribution limit. Some savers use Roth IRAs as a way of saving on a tax-deferred basis, with the intent of taking out contributed amounts tax-free when needed for tuition and other educational costs. Even a regular brokerage account can be a decent alternative, especially if you intend to buy and hold individual stocks. You'll still have to pay tax when you sell, but you'll defer it for years along the way.
2. High costs for some plans
There are dozens of different 529 plans, and not all of them are created equally. Some good 529 plans use low-cost index funds that have rock-bottom expense ratios. They'll never match the even lower costs that you could get on your own outside a 529 because the sponsors of 529 plans inevitably add their own fees on top of what the investment managers charge.
Where things get particularly bad, though, is with states that insist on using high-cost investment managers. You're not required to use your own state's 529 plan, but some states offer tax incentives that are only available if you stay in-state with your college savings. That can put you in the unfortunate situation of choosing a bad plan to get a tax break or to give up the tax break to get into a better plan. Making an informed decision on that front is a lot to ask from parents struggling just to get enough savings to set aside for college.
3. Penalties if your child ends up not going to college
Finally, 529 plans are good for educational savings, but not all kids end up going to college, and there are limits to what you're allowed to spend the money on. Money that goes toward education at trade and vocational schools is also eligible for the tax benefits from 529 plan withdrawals. However, it's possible that you'll have money left over in your 529 plan account -- especially if you save ambitiously early on.
However, if the money ends up not going toward post-secondary educational expenses and you simply take it out of the account, you'll owe income taxes plus a 10% penalty on any earnings the account has generated. There's an exception to the penalty if your child got a scholarship, but you'll still pay tax on the earnings. You also have the option of switching the beneficiary on the 529 to someone else, and you can always keep the 529 open to cover you if your child later decides to go back to school. Yet if you want that money back in your own pocket and the scholarship exception doesn't apply, then your only choice is to eat the taxes and penalties.
The best choice with 529 plans
Again, none of this is to say that putting money in 529 plans is always a bad thing. However, 529 plans aren't the one-size-fits-all perfect solution to everyone's college savings needs. Often, adding other alternatives like Coverdell ESAs, Roth IRAs, or regular investment accounts to complement a 529 plan will give you a better result than just relying solely on 529s alone.
