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Tax Efficient 529 Alternatives to Save for College

Author: Joel Baretto, CFP®
November 29, 2024

529 college savings plans have garnered widespread popularity as an effective means to amass funds for education expenses, and this popularity is well-justified. The funds injected into these accounts experience tax-deferred growth, and withdrawals are exempt from federal taxes as well as most state taxes, provided they are utilized for qualified educational expenses encompassing items like tuition, room and board, and fees. Many states further extend tax deductions or credits for contributions directed toward their respective plans. An additional advantageous feature lies in the absence of a contribution ceiling for 529 plans per annum (although states typically impose an overall aggregate contribution limit, which often remains substantial).

Despite the manifold advantages, 529 plans also present certain disadvantages, including the following:

  • For independent students without dependents, 529 funds are factored into the Student Aid Index (SAI) at a rate of 20%. Conversely, if the 529 funds are owned by a dependent student or a parent, they are considered at a maximum rate of 5.64%. Notably, 529 plans owned by grandparents and other individuals are not taken into account. A higher SAI translates to reduced financial aid eligibility.
  • The investment choices available within 529 plans can be notably restricted, frequently accompanied by higher fees.
  • The funds amassed must be allocated exclusively for qualified education expenditures. Should your child opt not to pursue higher education, and the funds are expended on non-qualified expenses, you will bear the responsibility of incurring taxes on the withdrawn contributions, alongside a potential 10% penalty on any earned amount withdrawn. However, commencing from 2024, an alternative emerges: you may now transfer a maximum of $35,000 from 529 plan assets to a Roth IRA designated for the beneficiary, given that the 529 plan has remained operational for a minimum of 15 years (adhering to established annual contribution limits).

These limitations are sufficient to prompt an investor to deliberate, particularly when considering the potential for their child to secure a substantial scholarship or the uncertainty surrounding their child’s higher education attendance. In light of these disadvantages, exploring supplementary avenues to amass funds for a loved one’s college expenses becomes prudent.

For Americans living abroad, this strategy may negate the intended tax savings, especially if you live in a county that does not recognize the tax-free nature of 529 plans thereby taxing you on its gains. Furthermore, finding a US custodian that will allow for a 529 plan is almost impossible due to cross-border regulations. The following options provide alternatives to 529 plans:

1. Coverdell Education Savings Accounts (ESAs)

A Coverdell Education Savings Account (ESA) serves as a tax-advantaged savings platform, enabling contributions of up to $2,000 per child per year until the child attains the age of 18. These funds can be allocated toward qualified education expenses, encompassing items such as tuition, books, and supplies, spanning from elementary school through college.

One primary advantage of a Coverdell ESA is its inherent flexibility, permitting the utilization of funds not exclusively for college-related costs. Moreover, this savings account variation allows for a broader array of investment choices compared to a 529 plan. While several 529s confine investments to mutual funds, Coverdell ESAs generally extend the opportunity for investors to engage in individual stock and bond investments as well.

While Coverdell ESAs foster tax-free growth of funds, it’s important to note that contributions to an ESA do not warrant any tax deductions. Additionally, a drawback surfaces in the form of a relatively limited income threshold for these accounts. Those with a modified adjusted gross income (MAGI) surpassing $110,000 as an individual or $220,000 as a married couple filing jointly are precluded from contributing to a Coverdell ESA.

2. Pre-Paid Tuition Plans

A pre-paid tuition plan is a distinct subset of the 529 plan category, albeit with a few distinctions. This particular plan variant empowers you to pay for your child’s forthcoming college tuition at present-day rates. Given the swift escalation of tuition costs in recent times, this strategy can culminate in substantial savings. While some states impose an upper limit on the permissible balance within your pre-paid tuition account, these caps usually stand at considerable levels, varying between $235,000 and upwards of $500,000.

However, the principal drawback of such plans lies in their confinement to certain colleges within a specific state, tethering the application of the tuition to these institutions. Furthermore, the funds are often exclusively earmarked for tuition and do not encompass other expenses such as room and board or fees. Nevertheless, if your child is certain about attending an in-state school covered by the plan, considering a pre-paid tuition plan could be a viable course of action.

3. Custodial Accounts

Uniform Gift to Minors Act (UGMA) and Uniform Transfer to Minors Act (UTMA) accounts are custodial accounts designed for parents to set aside funds for their children’s welfare. Though the balance within these accounts is specifically earmarked for the child’s benefit, it’s noteworthy that the assets need not be solely allocated for educational expenses, thereby providing some flexibility on how the funds are used for the benefit of the child.

Although it does not provide as much tax advantages as a 529, there may be some tax-deferred growth until the minor reaches the age of majority (18 or 21 depending on the state). Income generated from the account may be taxed at the child’s tax rate, which is typically lower than the parent’s rate, and can also lead to significant tax savings, especially if the child’s income remains below the taxable threshold. It’s essential to consider the tax implications carefully, especially regarding the “kiddie tax,” which can affect how much of the child’s unearned income is taxed at the parent’s rate once it exceeds a certain threshold.

Additionally, it’s vital to recognize that these accounts are regarded as your child’s assets, and up to 20% of the account balance might be factored into the calculation of your Expected Family Contribution (EFC) on the Free Application for Federal Student Aid (FAFSA). This could potentially adversely affect your child’s eligibility for need-based financial aid.

4. Roth IRAs

Primarily designed as vehicles for retirement savings, Roth IRAs can also be strategically employed for college savings purposes. These accounts permit post-tax contributions, and distributions that qualify (inclusive of education expenses) are devoid of tax liability. Withdrawals of contributions from the account are not subject to penalties since they stem from after-tax funds. Furthermore, earnings are also exempt from early withdrawal penalties when deployed to cover qualified education expenses.

An additional advantage emerges from the fact that Roth IRA contributions aren’t considered assets in the context of the Free Application for Federal Student Aid (FAFSA). However, it’s important to note that distributions must be disclosed as untaxed income or taxed income if the account has been active for fewer than five years.

A key drawback to using a Roth IRA for college savings pertains to the contribution cap, which stands at $7,000 annually, or $8,000 for individuals aged 50 and above (applicable as of 2024). This implies that if you are maximizing Roth IRA contributions to finance college expenses, you may inadvertently be under saving for your own retirement. Striking the right equilibrium between funding education and securing your financial future is imperative.

5. Tax Efficient Investment Portfolio

A tax efficient diversified investment portfolio can be a mix of cash, fixed, and equity assets. By utilizing low turnover and tax loss harvesting strategies, a well-managed investment portfolio can be tax efficient and may provide better than inflation growth over the long-term. Because long-term capital gains tax is currently at a rate of 0% – 20%, it is still preferrable to ordinary income tax rates.

Funds that remain unutilized for college-related expenditures have the capacity to continue growing for other financial objectives, including retirement.

Bear in mind that this strategy involves risk due to market fluctuations. Although the market may have outperformed inflation over longer periods of time, past performance is not a guarantee of future returns. Consult with a qualified wealth manager to properly assess your tolerance to risk and customize a corresponding suitable portfolio.

6. Maximum Funded Life Insurance

A universal life insurance policy with a cash value component that is linked to certain stock market indexes without the risk of negative returns may be a safe alternative to 529 plans. This strategy hits two birds with one stone by providing a lump sum tax free benefit in the event of death or safe growth over the long term with a potential for tax free distributions when the time comes. By overfunding the policy in accordance with tax compliant corridors, the excess funds trickle into a side account that may be linked to an index. A typical universal index life policy will provide a guaranteed floor of 0%-2% for years when the linked index is negative and a cap based on a volatility index for positive years, thereby providing a certain degree of safe growth over time. A well-executed strategy may provide a consistent tax-free cash flow when your child is ready for college.

Unlike 529 plans, this strategy is not limited to education planning and can be used for other long-term goals such as retirement income planning. This is a very complex strategy that requires a lot of compliance and number crunching to maintain its tax viability, growth and suitability. Make sure you consult with a qualified financial planner who understands the ins and outs of this strategy.

 Disclaimer:

  • The information provided is for educational purposes only and does not constitute personal financial, tax or investment advice and should not be relied on as such.  It does not take into consideration any investor’s particular investment objectives, strategies, time horizon, and tax or legal status. Abacus Wealth International (AWI) does not provide tax or legal advice.  Please consult a tax or legal professional for corresponding tax and legal advice. 
  • All material and content have been obtained from sources believed to be reliable.  AWI does not guarantee the accuracy of the information provided and shall not be held liable for decisions based on the foregoing information.  
  • All examples of graphs, financial products and historical returns contained in the foregoing material are for illustration and educational purposes only and shall not be deemed as financial advice or recommendation.  Past performance is not indicative of any future investment returns.