Section 529 plans can be a great way to save for college. In many cases, it is the best way for families and individuals to save for a student’s college expenses. However, it is not the only way. When you’re investing in a major goal like education, it makes sense to get familiar with all of your saving options.

U.S. savings bonds

U.S. savings bonds are backed by the full faith and credit of the federal government. They’re easy to purchase and are available in face values as low as $50, or $25 if purchased electronically. There are two types of savings bonds: Series EE, or Patriot bonds, and Series I bonds. Both are popular college savings vehicles.

Not only is the interest earned on them exempt from state and local tax at the time you redeem or cash in the bonds, but you may be able to exclude at least some of the interest from federal income tax as long as you’re eligible.

A 529 plan, which includes both college savings plans and prepaid tuition plans, may be a more attractive way to save for college. A college savings plan invests primarily in stocks through one or more pre-established investment portfolios that you generally choose upon joining the plan. So, a college savings plan has a greater return potential than U.S. savings bonds because stocks have historically averaged greater returns than bonds. While this has historically been true, it is important to note that past performance is no guarantee of future results.

However, there is a greater risk of loss of principal with a college savings plan: your rate of return is not guaranteed. This means that you could even lose some of your original contributions. By contrast, a prepaid tuition plan generally guarantees an annual rate of return in the same range as U.S. savings bonds. In some cases, a prepaid tuition plan can even be higher than savings bonds, depending on the rate of college inflation.

Perhaps, the best advantage of 529 plans is the federal income tax treatment of withdrawals used to pay qualified education expenses. These withdrawals are completely free from federal income tax no matter what your income and some states also provide state income tax benefits. The income tax exclusion for Series EE and Series I savings bonds is gradually phased out for couples who file a joint return.

However, keep in mind that if you use the money in your 529 account for anything other than qualified education expenses, you will owe a federal penalty tax on the earnings portion of the funds you’ve withdrawn. In some cases, you may owe state income taxes on the earnings portion of your withdrawal as well.

It is also important to note that there are typically fees and expenses associated with 529 plans. College savings plans may charge an annual maintenance fee, an administrative fee, and an investment fee based on a percentage of total account assets, while prepaid tuition plans typically charge an enrollment fee and various administrative fees.

Mutual funds

At one time, mutual funds were more widely used for college savings than 529 plans. Mutual funds do not impose any restrictions or penalties if you need to sell your shares before your child is ready for college.

Mutual funds also let you maintain more control over your investment decisions. For example, you can choose from a wide range of funds, move money among a company’s funds or from one family of funds to another, and make other decisions as you see fit. By contrast, you can’t choose your investments with a prepaid tuition plan.

With a college savings plan, you may be able to choose your investment portfolio at the time you join the plan, but your ability to make subsequent investment changes is limited. Some plans may let you direct future contributions to a new investment portfolio, but it may be more difficult to redirect your existing contributions. However, states have the discretion to allow you to change the investment option for your existing contributions once per calendar year or when you change the beneficiary. Check the rules of your plan for more details.

In the area of taxes, 529 plans trump mutual funds. There are no annual federal income taxes on the earnings within a 529 plan. Any withdrawals that you use to pay qualified higher-education expenses will not be taxed on your federal income tax return. However, if you withdraw any of the funds for noneducational expenses, you’ll owe income taxes on the earnings portion of the withdrawal, as well as a 10 percent federal penalty.

Tax-sheltered growth and tax-free withdrawals can be compelling reasons to invest in a 529 plan. In many cases, these tax features will outweigh the benefits of mutual funds. This is especially true when you consider how far taxes can cut into your mutual fund returns. You’ll pay income tax every year on the income earned by your fund, even if that income is reinvested. When you sell your mutual fund shares, you’ll also pay capital gains tax on any gain in the value of your fund.

Traditional and Roth IRAs

Traditional Retirement Accounts, (IRAs) and Roth IRAs, are retirement savings vehicles. However, because withdrawals for qualified higher education expenses are exempt from the 10 percent premature distribution tax, also called the early withdrawal penalty, that generally applies to withdrawals made before age 59½, some parents may decide to save for college within their IRAs. To be exempt from the premature distribution tax, any money you withdraw from your IRA must be used to pay the qualified higher education expenses of you or your spouse or the children or grandchildren of you or your spouse.

However, even if you’re exempt from the 10 percent premature distribution tax, some or all of the IRA money you withdraw may still be subject to federal income tax. Depending on what state you live in, it could also be subject to state income tax. Also, any withdrawals for college expenses will reduce your retirement nest egg, so you may want to think carefully before tapping your retirement funds to pay for your child’s education.

Custodial accounts

A custodial account holds assets in your child’s name. A custodian can be a parent, guardian, or other trusted individual. They will be responsible for managing the account and investing the money for your child until they are no longer a minor. It is important to note that a minor may be either 18 or 21 years old depending which state you live in. At that point, the account terminates, and your child has complete control over the funds. Many college-age children can handle this responsibility, but there is still a risk that your child might not use the money for college.

If you have a 529 instead of a custodial account, you do not have to worry about the risk of your college-age child misusing the money in their fund. This is because you will be able to decide when to withdraw the funds and for what purpose.

A custodial account is not a tax-deferred account. The investment earnings on the account will be taxed to your child each year. Under special rules commonly referred to as the “kiddie tax” rules, children are generally taxed at their parents’ presumably higher tax rate on any unearned income over a specified amount.

This amount is currently $2,200 according to the IRS. The kiddie tax rules apply to those under age 18, those age 18 whose earned income doesn’t exceed one-half of their support, and those ages 19 to 23 who are full-time students and whose earned income doesn’t exceed one-half of their support.

The kiddie tax rules significantly reduce the tax-savings potential of custodial accounts as a college savings strategy. Remember that earnings from a 529 plan will escape federal income tax altogether if used for qualified higher education expenses. The state where you live may also exempt the earnings from state tax.

A custodial account might appeal to you for some of the same reasons as regular mutual funds. Though the funds must be used for your child’s benefit, custodial accounts don’t impose penalties or restrictions on using the funds for noneducational expenses. Also, your investment choices are virtually unlimited (e.g., stocks, mutual funds, real estate), allowing you to be as aggressive or conservative as you wish. As discussed, 529 plans don’t offer this degree of flexibility.

It is also important to note that custodial accounts are established under either the Uniform Transfers to Minors Act (UTMA) or the Uniform Gifts to Minors Act (UGMA). The two are similar in most ways, though a UTMA account can stay open longer and can hold certain assets that a UGMA account can’t.

Finally, there is the issue of fees and expenses. Depending on the financial institution, you may not have to pay a fee to open or maintain a custodial account. You can typically count on incurring at least some type of fee with a 529 plan. College savings plans may charge an annual maintenance fee, an administrative fee, and an investment fee based on a percentage of total account assets, while prepaid tuition plans typically charge an enrollment fee and various administrative fees.

Trusts

Though trusts can be relatively expensive to establish, there are two types you may want to investigate further:

· Irrevocable trusts: You can set up an irrevocable trust to hold assets for your child’s future education. This type of trust lets you exercise control over the assets through the trust agreement. However, trusts can be costly and complicated to set up, and any income retained in the trust is taxed to the trust itself at a potentially high rate. Also, transferring assets to the trust may have negative gift tax consequences. A 529 plan avoids these drawbacks but still gives you some control.

· 2503 trusts: Two types of trusts can be established under Section 2503 of the Tax Code: the 2503c “minor’s trust” and the 2503b “income trust”. The specific features and tax consequences vary depending on the type of trust that is used, and there are myriad details that should be discussed with a financial advisor. Either type of trust is much more costly and complicated to establish and maintain than a 529 plan. In most cases, a 529 plan is a better way to save for college.

The Bottom Line

Investors should consider the investment objectives, risks, and expenses associated with 529 plans before investing. Additionally, it is important to understand why a 529 is typically the soundest way to save for your child’s education.

If you have questions about your current 529 plan, more information about specific 529 plans is available in the issuer’s official statement, which should also be read carefully before investing.

Finally, you should evaluate your state’s laws regarding 529 accounts. Some states have 529 plans that provide favorable tax benefits.

If you need additional guidance in making a college savings decision, be sure to reach out to our team of financial professionals at Navalign. We are uniquely positioned to help you plan for your financial goals including educational saving, retirement, and more.