Alternative to 529 plans (or how to save for college without tying up your money for 18 years)

June 20, 2008

I’ve mentioned over at Chief Family Officer that I plan to send my children to private school. One of the difficulties I run into when it comes to saving for college is that I don’t necessarily want to tie my money up for 18 years in a 529 plan when there’s a possibility, however slim, that we just might need it to pay for private school tuition.

While a 529 plan has many advantages, I hate the idea of paying a penalty if I need to withdraw the money before my kids start college. So I’ve been looking for alternatives to 529s, and here’s what I’ve come up with:

  • Coverdell ESA – This is the obvious alternative, and my favorite. The investment options within a Coverdell are akin to those in an IRA, and the funds can be withdrawn to pay for education-related funds starting in kindergarten. (Note: Even if your children attend public school, you may want to consider a Coverdell because funds can be used to pay for tutoring or even extended day programs.) Coverdell contributions are post-tax and growth is tax-free, like in a Roth IRA. The real downside is that contributions are limited to $2,000 per year. There is also an income limit for contributors. And unfortunately, the provision allowing funds to be used for grades K-12 expenses expires in 2010 unless Congress extends it.
  • Roth IRA – Contributions can be withdrawn at any time without penalty, so long as the account has been held for at least five years. Additionally, one of the exceptions to the early withdrawal penalty is college-related expenses. This means that if I needed the money before my kids enter college, I could withdraw the contributions I’ve made without penalty. And when they entered college, I could withdraw all of the funds. This assumes, of course, that I have adequate retirement savings in other accounts. The contribution limit is low compared to the limit for a 529 plan but I can’t save the maximum Coverdell and Roth IRA contributions while also paying for private school and saving for retirement anyway.
  • U.S. Savings Bonds – Under the Education Savings Bond Program, you don’t have to pay income tax on savings bonds used to pay for college expenses. There are income limitations and restrictions on which bonds qualify. Bonds must be held for five years or a penalty will be imposed upon redemption. The annual purchase limit for savings bonds has been reduced to $5,000. And the rate of return is low, especially considering how long the bonds will ideally be held (although your money will be extremely safe).

Obviously, your options are limited if you want to save for college in tax-advantaged accounts while avoiding having to pay a penalty if you withdraw your money early. But with the Coverdell and Roth options, you can save a decent amount each year that will still be accessible should you need it.

Have I left out any options?

8 responses to Alternative to 529 plans (or how to save for college without tying up your money for 18 years)

  1. Well, this is tough. Assuming you are using the retirement accounts for something crazy already, retirement, perhaps, the IRAs get knocked out. A real shame that Coverdell (The College account formerly known as ‘Education IRA’) is so limited. You say chilren, more than one, you’ll need to save far more than the $2000 Coverdell allows. But if they go to private school, the chance they go to college is nearly 100%, no? So why not put some in the 529, after topping off the Coverdell?

  2. Saving for your kids’ good. Very good post.

    Unfortunatly, not everyone can save for their children education. But those who can and don’t should start by reading this article.

    It’s so simple and it make a world of difference.

  3. We are in an interesting situation with respect to college funds, because we are also trying to avoid a 529. We live in America, but my husband is a French citizen, and his entire close-knit family lives over there. Where a college education is FREE. We plan to move over there, basically for this reason, in 9 years, once my older son (from a previous marriage) graduates HS.

    The dilemma is that our younger kids are American-born (though also French citizens) and bilingual/bicultural. So we are saving money in case they REALLY want to go to college here — and crossing our fingers that they will want to go over there!

    Because of all this, we don’t want to use a 529, because if they go to school over there, we’ll be hit with nice big penalties when we withdraw the money. So what we are doing is just putting our contributions into a regular old investment account, with low-cost funds that won’t throw off a bunch of taxable dividends. And hopefully, in 15 years, the money will be ours and it will be a nice retirement supplement. : ) (Or money for the kids to start businesses, or down payments on houses, or something like that.)

  4. Contributions from a Roth IRA can be withdrawn at anytime without penalty. There is no 5 year holding period requirement.

  5. does the Savings Bond program include paying back student loans? I have $1000 in bonds I would love to just dump out on my school loan.

  6. @TJ – Thanks for the correction!

    @Thomas – I don’t think so, unfortunately! But check the Treasury site or consult an accountant to be sure.

  7. I believe 529 funds can also be used at some “foreign” universities. Ditto re: JoeTaxpayer suggesting spillover into 529s. No tax on earnings, a possible state tax deduction, protection from bankruptcy creditors, favorable finanical aid treatment, etc. All are good, no?!!!!

    An added note re: the US Savins bonds–they must be owned/titled in the parent’s name, not be in the child’s name.

  8. I’d personally still try to put something in my 529 plan each month, even if you want to hold some out for private school.

    529 Plan Guide