Better Alternatives to 529 Plans

Mark Kennan for Demand Media writes: Using a 529 plan for college savings lets you save on a tax-deferred basis and use the money at any qualifying college, university or trade school. However, 529 plans aren't right for everyone because of restrictions on how the money is invested and spent. Considering alternative savings methods helps you make sure you're making the right choice.

COVERDELL ESA

Coverdell Education Savings Accounts function similarly to 529 plans: you contribute after-tax dollars, those dollars grow tax-free while in the account, and when you take the money out, you don't pay taxes as long as you're using it for qualified educational expenses. The difference lies in what counts as qualified expenses: Coverdells let you spend the money on elementary and secondary school as well as college, which means if Junior's breaking your bank going to a private high school, you can tap your Coverdell. If you tapped a 529 plan, you'd owe income taxes and a 10 percent penalty on the earnings. The downside to the Coverdell is you're limited to $2,000 per year in contributions and your income must fall below certain annual limits.

ROTH IRAS

Yes, the "IRA" in Roth IRA stands for individual retirement account. But, that doesn't mean that's all it can be used for. You won't get a tax deduction for contributions, but you can put in up to $5,500 per year -- $6,500 if you're 50 or older -- as of 2013, as long as your income falls below the annual limits. Once the money's in, it grows tax-free until you take distributions. But wait, you say, don't you have to use the money for retirement? Nope. In fact, you can get your contributions out tax-free and penalty-free any time you want. Plus, if you're 59 1/2 and have had a Roth IRA open for at least five years by the time your kid goes to college, you get the earnings out tax-free, too. Even if you're not, you won't owe the early withdrawal penalty because college tuition payments are exempted from the penalty. Plus, the Roth IRA won't appear as an asset on your kid's financial aid application.

CUSTODIAL ACCOUNTS

You can gift your kid up to $14,000 per year without triggering any gift taxes, as of 2013. Putting it in a custodial account gives you control over the spending, but only until the child becomes an adult, typically between 18 and 21, at which point the money belongs to your child -- and you can't make her use it for college. But, unlike a 529 plan, if your child decides to start her own business after high school, you don't have to worry about nonqualified withdrawal penalties from a 529 plan. Plus, the income on the money in the custodial account won't be tax-sheltered, but all or a part of it might be taxed at the child's lower rate.

TAXABLE ACCOUNTS

Before you tune out because of the word "taxable," hear out the reasons it might be to your advantage. Using a regular investment account means you get to pick how the money's invested. With a 529 plan, you're stuck picking one of the state-approved investment options and you're only allowed to switch investments once per year. Plus, any money you take out of your 529 plan to pay for college can't count toward getting you an education tax credit, like the lifetime learning credit or American opportunity credit.