Is 529 the Best Way to Save for College?

Paying for higher education is a substantial financial undertaking. With the rising cost of tuition and living expenses, saving early is a high priority for many families. Among the available savings tools, the 529 plan is one of the most recognized. Named after Section 529 of the Internal Revenue Code, these accounts are often synonymous with college savings.

The prominence of 529 plans leads many to assume they are the best choice. Sponsored by states and educational institutions, these accounts provide tax advantages for education savings. However, families must determine if this popular vehicle is the optimal strategy for them or if other options are a better fit.

Understanding 529 Plans

A 529 plan is a tax-advantaged investment account designed to encourage saving for future education costs. The more common type is the college savings plan, where an account owner invests in portfolios, and the account’s value fluctuates with market performance. The second type, a prepaid tuition plan, allows for the pre-purchase of tuition credits at current prices, but these are less common and offer less flexibility. In both cases, the account owner, often a parent or grandparent, maintains control over the funds.

While there are no plan-specific annual contribution limits, contributions are considered gifts for tax purposes. An individual can contribute up to the annual gift tax exclusion amount, $19,000 in 2025, without incurring gift taxes. A unique feature called “superfunding” allows a contributor to make a lump-sum contribution of up to five times that amount ($95,000 for an individual) and treat it as if it were made over five years. Aggregate contribution limits are set by each state and can exceed $500,000 per beneficiary.

The tax treatment of 529 plans is a significant benefit. Contributions are made with after-tax dollars, but investments grow tax-deferred, and withdrawals are federally tax-free when used for qualified education expenses. Many states also offer a state income tax deduction or credit for contributions. Qualified expenses include tuition, fees, books, supplies, and required equipment. Room and board also qualify for students enrolled at least half-time. The definition has expanded to allow up to $10,000 annually for K-12 tuition and a lifetime maximum of $10,000 to repay qualified student loans.

A provision from the SECURE 2.0 Act allows for tax-free and penalty-free rollovers from a 529 plan to a Roth IRA for the beneficiary, offering a solution for leftover funds. This is subject to a lifetime limit of $35,000 and requires the 529 account to have been open for at least 15 years. If funds are withdrawn for a non-qualified purpose, the earnings portion is subject to income tax plus a 10% federal penalty.

For financial aid purposes, a 529 plan owned by a parent or dependent student is reported as a parental asset on the Free Application for Federal Student Aid (FAFSA). These assets are assessed at a maximum rate of 5.64% in the Student Aid Index (SAI) calculation, which is much lower than the 20% rate for assets held in a child’s name.

Exploring Coverdell Education Savings Accounts

A Coverdell Education Savings Account (ESA) is another tax-advantaged vehicle for education savings. Unlike 529 plans, Coverdell ESAs have strict limitations. The total contribution for a single beneficiary cannot exceed $2,000 per year from all sources. This low annual limit means these accounts often serve as a supplemental savings tool rather than a primary one.

Eligibility to contribute is also restricted by income. For 2025, the ability to contribute is phased out for single filers with a modified adjusted gross income (MAGI) between $95,000 and $110,000 and for joint filers with a MAGI between $190,000 and $220,000. Like a 529 plan, contributions are not federally deductible, but investments grow tax-deferred, and withdrawals are tax-free for qualified education expenses. On the FAFSA, a Coverdell ESA is also treated as a parental asset.

Coverdell ESAs have specific age-related requirements. Contributions must stop when the beneficiary turns 18, and any remaining funds must be distributed within 30 days of the beneficiary turning 30. If not, the earnings become taxable and are subject to a 10% penalty. To avoid this, the balance can be rolled over to a Coverdell ESA for another eligible family member.

Using Roth IRAs for Education Savings

A Roth IRA’s primary purpose is retirement savings, but its structure offers flexibility for education funding. A Roth IRA is funded with after-tax dollars, and qualified distributions in retirement are tax-free. This dual-purpose potential makes it an interesting option for families saving for multiple long-term goals.

The withdrawal rules make a Roth IRA a viable education savings tool. An individual can withdraw their direct contributions at any time, for any reason, without taxes or penalties. This provides a high degree of flexibility, as the funds are not locked away and can be accessed for major expenses like college.

Withdrawing earnings before age 59 ½ would normally trigger income tax and a 10% penalty. However, an exception for qualified higher education expenses waives the 10% penalty, though the withdrawn earnings are still subject to ordinary income tax. This exception applies to expenses for the IRA owner, their spouse, children, or grandchildren.

For financial aid purposes, retirement assets, including Roth IRAs, are not reported on the FAFSA. This means the account balance does not impact a student’s eligibility for need-based aid. However, the withdrawal itself is reported as income on the FAFSA two years later, which can affect aid eligibility in subsequent years.

Custodial Accounts and Other Savings Vehicles

Families can also use custodial accounts established under the Uniform Transfers to Minors Act (UTMA) or the Uniform Gifts to Minors Act (UGMA). These accounts allow an adult to transfer assets to a minor without a formal trust. The contributions are an irrevocable gift, and the assets legally belong to the child, managed by a custodian until the child reaches the age of majority, typically 18 or 21.

The tax implications for these accounts are governed by “kiddie tax” rules. For 2025, the first $1,350 of a child’s unearned income is tax-free, the next $1,350 is taxed at the child’s rate, and any unearned income over $2,700 is taxed at the parents’ rate. This is less advantageous than the tax-free growth offered by 529s and Coverdells.

The most significant drawback is their impact on financial aid. Because the assets are legally owned by the child, they are assessed at the 20% student asset rate on the FAFSA, which can substantially reduce need-based aid. Once the child reaches the age of majority, they gain full legal control of the assets and can use them for any purpose.

A standard taxable brokerage account is another alternative, offering maximum flexibility with no contribution limits or use restrictions. However, this comes at the cost of tax efficiency. All investment earnings, including dividends and capital gains, are taxed annually, which can slow the account’s growth compared to tax-advantaged options.

A Comparative Analysis for Decision Making

Choosing the right savings vehicle depends on a family’s specific financial situation, risk tolerance, and goals. Factors like income, desired control over the assets, and the potential need for financial aid all play a role in the decision.

While 529 plans offer powerful tax advantages and favorable aid treatment, alternatives provide different benefits. Coverdell ESAs, Roth IRAs, and custodial accounts each present a unique mix of flexibility, control, and tax implications. Families may find that a combination of these accounts is the best strategy to meet their education savings goals.