Alternatives to 529 College-Savings Plans

Saving for college is already a big concern for most families, and with costs soaring higher each year, it's likely to grow even more important. Many investors are turning to 529 college-savings plans to tackle this growing financial burden. No doubt the plans have appeal. Available mainly at the state level, they offer portfolios of mostly mutual funds and come with attractive tax savings for all investors, regardless of income levels. And while once pricey and mostly mediocre, many now boast lower fees and improved investment options, giving them better odds of success, more flexibility, and enhanced diversification.

Still, 529 college-savings plans aren't a perfect solution for everyone. For one, while the industry is improving, some states continue to hawk poorly constructed plans, and even the tax incentives aren't enough to compensate investors for the lackluster returns they'll earn from the mediocre funds and layers of fees. Plus, what if your child opts out of college? Because 529 plans are customized for higher education purposes only, college savers can face taxes and a steep penalty if they can't find another beneficiary to claim. There's no great out for leftover assets, either. If a beneficiary doesn't use up all the assets on approved education expenses, the amount remaining will also be sliced by taxes and penalties. Finally, although college savings are an important concern for most families, financial distress can sometimes mean a college saver needs the 529 assets for different purposes. Sorry, no dice. Whatever the reason, if the 529 assets aren't used for post-secondary education, investors are slapped with big tax bills.

Thus, before jumping into a 529 plan, we'd suggest assessing your particular situation. If 529 plans don't appear to meet your needs, consider alternatives. Below, we discuss the merits and drawbacks of a few of the other options college savers can consider.

Coverdells
Like 529 plans, these savings vehicles are designed to offer tax-free asset growth in the name of education. The structure here is a bit different, though. Coverdells are not offered by states; they are available through various channels, including banks and mutual funds. And instead of focusing solely on college and grad-school expenses, investors can currently use Coverdell assets to pay for anything from kindergarten on up. There's quite a bit of flexibility, too. Investors retain control over their accounts and have a variety of choices at their fingertips--from CDs to mutual funds.

Before getting too excited about the possibilities, though, there are some serious drawbacks to consider. Not just anyone can invest in a Coverdell: The contributor's annual income must be below a specific minimum (currently $220,000 for married couples filing jointly). And unlike 529 plans, states don't offer tax deductions for contributions to Coverdell accounts, so all contributions are made on an aftertax basis. Age limits make Coverdells a bit unwieldy, too, because contributors can't add to their assets after the beneficiary turns 18 and the beneficiary faces taxes and a penalty if the assets aren't distributed by the time he or she turns 30. Finally, Coverdell assets are considered the property of the beneficiary, so they are counted more heavily than 529 savings plans when it comes to financial aid awards.

These disadvantages might be worth it, given the other features Coverdells bring to the table. Unfortunately, barring any federal government actions, the most appealing aspects might soon disappear. In 2001, legislation upped what investors can contribute to as much as $2,000 annually, but this level is set to expire in 2010. Unless Congress takes action, starting in 2011 the educationally-minded will be able to sock away only $500 a year. The same is true for applying assets to primary and secondary education costs. If Congress doesn't move to extend this benefit, investors will be able to use Coverdell assets only for college and grad school education.

U.S. Savings Bonds
Before Coverdells or 529s, there were U.S. savings bonds. And while they may be old-fashioned, they're still worth a look for conservative types. The interest earned by U.S. treasury obligations isn't taxed at the state level, and if investors use Series EE or Series I savings bonds to pay for college and beyond, the interest earned won't be taxed at the federal level either. Series I bonds are particularly attractive. They are structured to offer some inflation protection. But regardless of the savings bond you choose, you won't face annual account maintenance fees, and if the student ends up not going to college, you won't pay any penalty besides paying federal income tax on the interests. Also, because U.S. savings bonds are protected by the full faith and credit of the U.S. government, safety isn't a concern.

As always, there's a downside. Barring the unforeseen, U.S. savings bonds aren't going to turn you from a pauper to a tycoon any time soon. Their muted volatility is accompanied by muted returns. Also, beware of the restrictions. Like Coverdells, these bonds aren't designed for everyone; only folks under certain income levels benefit from the federal tax breaks. They're also available for college saving only to those 24 and older.

The Standard Brokerage Account
First the bad news: Unless you stick with tax-exempt bond funds or rely on successful, tax-conscious funds, you won't evade the tax collector with a traditional brokerage account. Even with tax-managed offerings, you'll likely have to pay the piper every now and then--albeit in smaller amounts. Nonetheless, there are still two very important reasons to consider opening a plain-vanilla brokerage account to save for college. First, investors have complete control over their investment decisions and can stack their portfolios with best-of-breed mutual funds. Second, while there are expenses associated with brokerage accounts, and they can add up if you are a frequent trader, investors can avoid the layers of fees at 529s or Coverdells. That means investors can put more of their money to work for them. So while the tax bill is a significant disadvantage, a cheap, well-constructed portfolio might still put an investor in a great position for college expenses.

Home Equity Loans
There's more than one way to skin a cat. Instead of saving and investing to pay for college, homeowners can also tap their home equity, or the difference between what their home is worth and what they still owe in mortgage payments. The upside is that the interest on a home equity loan is tax-deductible. Plus, while 529 plans and Coverdells can make for less financial aid, if college payers rely on a home equity line of credit, the loan shouldn't come into consideration. (A home equity line of credit means the borrower gets the money as it's needed, and not as a lump sum at the beginning of the loan.) Of course, as the current market showcases, real estate prices don't always go up, and interest rates on home equity lines of credit are now considerably higher than they were just a year ago. So, college savers should do what they can to ensure they aren't biting off more than they can chew by taking on another loan. In the worst-case scenario, a home's value falls at the exact time the borrower needs to move. Saddled with two loans and a cheaper house, he or she could face a painful financial situation.

Additional Considerations
There are still more ways to handle the price of a college education. Trust funds aren't just for the silver-spoon set, for example. College savers don't need millions to set one up, and although there are lots of associated fees, an appropriately drafted trust protects the money in case of catastrophe and also doesn't incur a penalty if it's not used for education purposes. Borrowing against a life insurance policy is also an option, although the downside here is if the loan is outstanding when the owner of the policy passes away, the payout is reduced by the loan balance.

Don't forget financial aid, either. There are reams of scholarships and loans available, offered by schools, private organizations, and the government. And remember: The college-bound don't have to go to four years at a private school. Be sure to consider alternatives, such as state schools or community colleges, many of which offer sound education at a much lower price.

Summing Up
With costs of college climbing at a rapid clip, it pays to be creative. Investigate 529 plans, but don't forget to explore whether other options might be a better fit for your financial situation. You can even combine different options if that works best. After doing your homework, you might realize the best option is one you never considered before.

For more details on college-savings options, "529 & Other College Savings Plans For Dummies" is a good step-by-step guide.

A version of this article originally ran in our Morningstar Mutual Funds publication.