With Inflation so High, Are 529 Plans Still Worth It?

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KEY POINTS

  • A 529 plan allows you to enjoy tax-free investment gains in the course of saving for college.
  • There's another plan you may want to consider if you're trying to fund an education.
  • It's a good idea to consider using a Roth IRA for college savings instead.

There may be a better option for saving for college.

It's an unfortunate fact that many people graduate college saddled with debt. If that's a fate you want your children to avoid, then you may be making a solid effort to sock money away for higher education. And you may be inclined to keep that money in a 529 plan.

A 529 plan is a tax-advantaged educational savings plan. The money you put into a 529 generally doesn't get tax-advantaged treatment, but you can invest your 529 in the hopes of growing it into a larger sum. And as long as you use your 529 funds to cover education costs, your withdrawals will be tax-free. That means you won't get stuck paying taxes on investment gains like you would with a regular brokerage account.

Meanwhile, it's no secret that inflation has been soaring this year. But actually, education-related inflation has been out of hand for years. And so rather than keep your college fund in a regular savings account, it's a good idea to invest that money so it grows into a larger sum over time.

A 529 plan, however, may not be your best choice in that regard.

A better home for your money

Right now, savings accounts are paying more interest than they have in the past. And so you may be inclined to keep your education funds there. But even if you manage to snag an interest rate of about 3% on your savings, that may not be enough to keep up with inflation as it relates to the cost of college. That's why investing your money is so important.

But you may not want to stick to a 529 to build college or educational savings. While 529s offer the aforementioned tax break, they also penalize you on your gains if you take a withdrawal for non-education purposes.

And also, 529 plans often come with limited investment choices. In some cases, you may be forced to invest too conservatively. That could limit your ability to have your savings outpace inflation.

That's why you may want to consider a Roth IRA as your education fund instead. Roth IRAs are generally meant to serve as a means of retirement savings (after all, IRA stands for "individual retirement account"). And to be clear, it's not a good idea at all to tap an existing Roth IRA meant for retirement to fund an education.

But if you're not thrilled with the idea of opening a 529 plan, you can save for college in a Roth IRA that's earmarked for that specific purpose. You'll get the same benefit as a 529 -- tax-free gains in your account and tax-free withdrawals -- only you won't face any penalties for taking a withdrawal for purposes outside of paying for education.

In fact, let's say you save up $80,000 for college in a Roth IRA, only your child gets a scholarship that only has you paying $15,000 a year for college. You can then simply reserve your remaining $20,000 for retirement -- it's that simple.

Of course, you may be thinking, "Wait a minute. Won't I be penalized for taking an early Roth IRA withdrawal if I'm not 59 ½?" But actually, you can withdraw funds from a Roth IRA at any age to pay for higher education without penalty.

Now one thing you should know is that Roth IRA withdrawals used to pay for education are tax-free with regard to your principal contributions. If you touch the gains portion of your account to pay for college, taxes can apply there. But either way, you're really not taking a very big risk, because if you end up being able to avoid touching the gains portion of your account, you can always reserve it for retirement.

You may want to skip the 529 plan

Although 529 plans are an appropriate choice for a lot of people who want to save for college, they may not be ideal for you. You may want to talk to a financial advisor to determine the best place for your education fund.

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