Though investing in a college savings plan is typically the most efficient and cost-effective way to save for college or other education-related expenses, it’s not the only way. The most popular alternatives are:
- Uniform Gift to Minors Accounts (UGMAs)
- I401(k) retirement savings accounts
- IRA retirement accounts
- Taxable investing accounts
- Home equity loans
Though you should be aware of these alternatives, it’s crucial to understand their pitfalls and limitations as education related funding sources.
Uniform Gift to Minors Accounts (UGMAs)
Uniform Gift to Minors Accounts (UGMAs) allow any adult to set up a savings account for any minor beneficiary (anyone under age 18). UGMAs have several tax advantages:
- While the beneficiary is still a minor: The first $800 of earnings in an account for a child under the age of fourteen is not taxed while the next $800 is taxed at the child’s rate and amounts above $1,600 are taxed at the parent’s marginal rate. For children over the age of fourteen, earnings are taxed at the child’s rate.
- When the beneficiary turns 18: Earnings over $850 are taxed at the beneficiary’s tax rate at the time he or she withdraws money.
Though UGMAs offer more favorable tax treatment than regular taxable investing accounts, they don’t match the opportunity for tax-free earnings and withdrawals that college savings accounts, such as 529 plans, can offer.
401(k) Retirement Savings Accounts
IRS rules allow retirement account owners to withdraw funds from and 401(k)s without penalty when these funds are used for qualified higher education–related expenses. Even so, it’s best to avoid spending any retirement savings on education expenses, since doing so could jeopardize your ability to retire.
IRA Retirement Savings Accounts
If you absolutely must withdraw from an IRA retirement account to pay for education-related expenses, always withdraw first from your traditional IRA as opposed to your Roth IRA plan. Withdrawals from Roth-style retirement accounts, such as Roth 401(k)s and Roth IRAs, require you to pay regular income tax on the account’s capital gains at the time of withdrawal, which compromises the main advantage of investing in a Roth IRA—tax-free withdrawals.
Taxable Investing Accounts
Taxable investing accounts are ordinary investing accounts in which you buy stocks, mutual funds, and so on. Though these accounts offer the most investment options and grant the account owner complete control of the account’s assets, they don’t offer the advantages of college savings accounts, namely favorable tax treatment and prepayment of tuition.
Home Equity Loans
Home equity loans allow you to borrow money against the equity you’ve built up in your home—the difference between what you owe on the home and its current market value. Though the interest you pay on a home equity loan is tax-deductible, usually it’s best to avoid using a home equity loan to fund education-related expenses, since these loans offer none of the benefits of college savings accounts.