It's possible to find more flexibility by going outside of 529s, but not without trade-offs.
Question: My wife and I are trying to save for college for our two daughters. However, I'm primarily a stock investor and don't like the idea of having to stick with a preset menu of investment options, as I'm required to do with a 529 College Savings plan. Is there an equivalent to IRAs for college savers that would allow me to invest in the securities of my choice?
Answer: For better and for worse, the deck has been stacked in favor of 529 plans for college savers. No other college-savings vehicle offers the same combination of extremely generous contribution limits, tax-free compounding, and tax-free withdrawals when you use the money to pay for qualified college expenses; potential state tax breaks on 529 contributions are the icing on the cake. Although there are still some stinkers among 529 plans, in general the plans have been getting better over the years, as Morningstar's Laura Pavlenko Lutton pointed out in her most recent report about the best 529 plans.
However, your question points up the key drawback of 529 plans: Even though many plans offer broad suites of investment options, they don't give you the same latitude to select your investments that you might have within an IRA or brokerage account. Assuming you'd like to exert more control over your investments while also saving for college, you could consider the following options, or possibly some combination of them.
Coverdell Education Savings Account
Think of Coverdell ESAs as Roth IRAs for college savers. You can put a huge array of investments inside of a Coverdell, including individual stocks and mutual funds, thereby addressing your desire to have more control over the investment options. Coverdells also enjoy some of the same tax benefits that 529s do: Although contributions aren't tax-deductible in either type of account, your investments grow tax-deferred and withdrawals aren't taxable if they're used to pay for qualified college expenses such as tuition and room and board. (Note, however, that money withdrawn from a Coverdell may be partially taxable for families who are also taking advantage of other college-tuition tax breaks in the same year, including tax deductions for tuition payments or Hope and Lifetime Learning credits.) Coverdells, like 529s, are also considered assets of the parents and therefore shouldn't be a major impediment to financial-aid eligibility.
So far so good, right? Well, the Coverdell carries a couple of caveats that could limit its attractiveness, especially for higher-income investors looking to sock a lot away for college. First, you're limited to contributions of $2,000 per year per beneficiary; that limit is set to go even lower--to $500--in 2013, barring congressional action. If you're aiming to buy individual stocks for your daughters' accounts, you might have trouble obtaining adequate diversification given that limit. Second, there are income limitations that govern who can contribute: Individual filers earning more than $110,000 in modified adjusted gross income and married couples filing jointly and earning more than $220,000 cannot contribute to a Coverdell.
Taxable Brokerage Account
One other option is to buy stocks for college within the confines of a taxable brokerage account. You'd have the broadest possible array of investment choices, and you wouldn't confront any income or contribution limits. You could also limit year-to-year taxes by buying and holding non-dividend-paying stocks or index funds and exchange-traded funds, then gradually segueing into a bigger share of municipal bonds as your girls' college days draw near.
The big drawback, obviously, is that you'd owe tax on your investment earnings when it comes time to withdraw the money to pay for college, something you'd be able to circumvent by opting for a 529 or Coverdell.
Although Roth IRAs are primarily for retirement savings, they can have applications for college savers, too. True, there are a few limitations on what you can put inside an IRA (artwork and antiques are off-limits, for example) but you have broad latitude to invest in securities such as individual stocks, funds, ETFs, and certificates of deposit. You'll also be able to harness some tax benefits. When investing in a Roth, you won't owe taxes from year to year, and you can withdraw your contributions at any time and for any reason--including to pay for college--without owing taxes or a penalty. Moreover, you can also withdraw the investment earnings if you're using the money to pay for college. You'll owe tax on that portion of the distribution, but you can circumvent the 10% early-withdrawal penalty that normally applies to pre-retirement distributions.