529 Alternatives: Options for Education Savings

Many financial accounts can serve as effective vehicles for education savings beyond 529 plans. These alternatives come with their own distinct sets of regulations, tax consequences, and strategic advantages. Understanding these options allows for a more tailored approach to saving for future academic costs that aligns with specific financial goals.

Coverdell Education Savings Accounts

A Coverdell Education Savings Account (ESA) is a tax-advantaged account for education savings. The annual contribution limit is $2,000 per year for each beneficiary. While multiple people can contribute, the total amount from all sources for that beneficiary cannot exceed the annual cap.

Eligibility to contribute is subject to income limitations based on Modified Adjusted Gross Income (MAGI). For single filers, the ability to contribute phases out at a MAGI of $95,000 and is eliminated at $110,000. For joint filers, the phase-out range is between $190,000 and $220,000.

Although contributions are not tax-deductible, the investments within the account grow tax-deferred. A significant benefit is that withdrawals are entirely tax-free at the federal level, provided they are used for qualified education expenses. This allows the full value of the account’s growth to be applied toward educational costs.

Coverdell ESAs can be used for a broad range of costs for K-12 and higher education. Qualified expenses include:

• Tuition and fees
• Books, supplies, and equipment
• Academic tutoring
• Uniforms and transportation

The account provides a wide range of investment options, including stocks, bonds, and mutual funds. The assets in a Coverdell ESA must be used by the time the beneficiary reaches age 30. If funds are not used by this deadline, they can be rolled over to a qualifying family member’s ESA to avoid taxes and penalties.

Using Retirement Accounts for Education Funding

A Roth IRA can function as a dual-purpose savings vehicle for education and retirement. A fundamental rule is that an individual can withdraw their direct contributions at any time, for any reason, completely free of taxes and penalties because they are made with post-tax dollars.

This ability to access contributions provides flexibility. If education costs are lower than anticipated or if a child receives scholarships, the funds can remain in the Roth IRA for retirement. This allows parents to save for education without the risk of tying up money in a dedicated account that might not be fully needed.

The treatment of investment earnings has specific provisions for education. While earnings normally must remain in the account until age 59½ to be withdrawn tax-free, an exception exists for qualified higher education expenses. Under this rule, you can withdraw earnings early to pay for college costs without the 10% penalty, but the earnings will be subject to ordinary income tax.

For a withdrawal of earnings to be penalty-free, the amount cannot exceed the qualified higher education expenses for the year. For a student at an eligible institution, these expenses include:

• Tuition and fees
• Books
• Supplies
• Required equipment

In contrast, using a Traditional IRA for education funding is less advantageous. Withdrawals from a Traditional IRA are always subject to ordinary income tax. While there is an exception to the 10% early withdrawal penalty for education expenses, the entire distribution is taxable.

Custodial Accounts Under UTMA and UGMA

Custodial accounts under the Uniform Transfers to Minors Act (UTMA) or Uniform Gifts to Minors Act (UGMA) are used to hold assets for a minor beneficiary. Any contribution is an irrevocable gift to the child, meaning the money legally belongs to them. A custodian, typically a parent, manages the account on the child’s behalf.

Once the beneficiary reaches the age of termination, which varies by state but is often 18 or 21, the custodian must transfer control of the account. The former minor then has full control over the assets and can use them for any purpose. This lack of restriction on use presents a risk if the child does not use the money for education.

The tax implications are governed by “kiddie tax” rules, which apply to a child’s unearned income from investments. For 2025, the first $1,350 of unearned income is tax-free, and the next $1,350 is taxed at the child’s rate. Any unearned income exceeding $2,700 for the year is taxed at the parents’ higher marginal tax rate.

Custodial accounts have a significant impact on financial aid eligibility. Assets in an UTMA or UGMA account are reported as the student’s assets on the FAFSA. Student assets are assessed more heavily than parental assets, with up to 20% counted toward the Student Aid Index (SAI) compared to a maximum of 5.64% for parental assets, potentially reducing aid.

General Investment and Savings Vehicles

Standard taxable brokerage accounts offer the most flexibility for education savings. There are no contribution limits, income restrictions, or rules on how the money must be spent. This control is advantageous if a student’s plans change or funds are needed for other goals.

The main financial consideration is the tax treatment of investment gains, as there are no special tax breaks. When investments are sold, any profit is subject to capital gains tax. Profit from assets held over a year is taxed at long-term rates, while profit from assets held a year or less is taxed as ordinary income.

Another option is using U.S. Savings Bonds, specifically Series EE and Series I, through the Education Savings Bond Program. This program allows you to exclude the interest earned from federal income tax when proceeds pay for qualified higher education expenses. State and local income taxes also do not apply to the interest.

To qualify for the tax exclusion, the bond must be issued after 1989 to a person who was at least 24 years old and must be in the parent’s name. The tax exclusion is also subject to income limitations in the year the bonds are redeemed. For 2024, this benefit phases out for joint filers with a MAGI between $145,200 and $175,200, and for single filers between $96,800 and $111,800.

Advanced Gifting and Insurance Strategies

More complex strategies for education funding include vehicles like cash-value life insurance and certain types of trusts.

Permanent life insurance policies accumulate a cash value that grows tax-deferred. Policyholders can access this cash value via an income tax-free policy loan. While the cash value is not typically an asset in financial aid calculations, these policies involve high premiums and loans reduce the death benefit.

Irrevocable trusts, such as a Crummey trust, are an advanced method for gifting assets for education. This trust allows a grantor to make gifts that qualify for the annual gift tax exclusion while restricting when the beneficiary can access funds. The structure gives the beneficiary a temporary window to withdraw a contribution, classifying it as a “present interest” gift for tax purposes.

These trusts allow for transferring wealth while maintaining control over assets long after a child reaches the age of majority. They can be designed to distribute funds for specific purposes like education. However, establishing and administering an irrevocable trust is a complex and costly undertaking suited for those with substantial assets.