Pros and Cons of 529 Plans: Should You Open One for College?

 March 31, 2021
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pros and cons of 529 plans

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The faster you can start planning for the cost of college, the better. In fact, parents with as little as $500 in a 529 college savings plan are more likely to see their child graduate from college, according to The Education Plan.

With that said, a 529 plan isn’t the only option for parents paying for college. Check out the following pros and cons of 529 plans to help choose the best savings vehicle for your family.

5 pros of 529 plans 5 cons of 529 plans
1. Multiple plan options
2. Shop around from state to state
3. Potential tax advantages
4. Funds can be used pre-college too
5. Switch beneficiaries with ease
1. Significant upfront costs
2. Savings could reduce need-based aid
3. Penalties for noneducational withdrawals
4. Fines for ill-timed withdrawals
5. One-size-fits-all investment options
Plus: Weigh the pros and cons of 529 plans

5 pros of 529 plans for college

You can save up for your child’s future education expenses over time using 529 plans. These tax-advantaged plans often put you in the driver’s seat as a manager. Here are the specifics.

1. You have options when selecting a plan

There are two basic types of 529 plans:

  • Prepaid tuition plans: You lock in current tuition rates at in-state public institutions. If your child decides to go to a private or out-of-state institution, you might receive only a small return on your original investment.
  • Savings plan: You contribute regularly and rely on the account’s earnings to grow. You take on more investment risk while giving your child the opportunity to use the funds at public and private schools nationwide.

2. You can shop around from state to state for a savings plan

Once you figure out which 529 plan is right for you, you can shop around. You don’t have to be a resident of a state to participate in its saving plan.

When choosing a savings plan, you might prioritize a state that caters to your investment style. You might also be tempted to stick with your home state’s plan if it offers a tax credit or other benefit.

In Colorado, for example, the CollegeInvest Matching Grant Program gives eligible residents up to $2,500 over five years when they open and contribute to a 529 plan.

Also, keep in mind that not all 529 plans are created equal. Some have higher fees than others, so that could be another determining factor.

3. You might not have to pay taxes on the plan’s earnings

If you select a 529 savings plan, you’re tying your contributions to the stock market. Over an extended period, your contributions should grow with the market.

A big pro of the savings plan is that you don’t pay federal or — in most cases — state taxes on that growth as long as your child uses the funds for qualifying education costs. Eligible costs include tuition, books and room and board. If the expense doesn’t qualify, a withdrawal from the plan would be taxed and subject to a 10% penalty.

One exception is if your child earns a scholarship, fellowship or employer-based tuition assistance. You could withdraw an equal amount from the account without facing the 10% penalty.

With your savings at stake, it’s important to understand how 529 plans are taxed.

4. It’s becoming easier to use the funds for pre-college education

You could use 529 plans to pay for tuition, fees, college textbooks and room and board. As of 2009, you could also use the plans to pay for your student’s computer equipment and internet access.

But until more recently, those expenses had to be related to paying for college. The Tax Cuts and Jobs Act passed by Congress in December 2017 allows you to use up to $10,000 of plan savings annually for private education between kindergarten and high school.

5. You could switch beneficiaries without penalty

You might be concerned that your child will skip college down the road. That could leave you with a full savings plan but no one to use it. What do you do with leftover money in a 529 plan?

Luckily, you can change the beneficiary of your 529 savings plan without suffering tax consequences. Maybe a younger child in the family could use the funds, or you’re considering going back to school. You could also roll over one 529 plan balance into another plan if one of your children doesn’t need the money.

And if you have a family member who already went to school and accumulated student loan debt, you could use 529 plan funds to help repay it. Thanks to the Secure Act passed into law in 2019, you could up to $10,000 of such savings toward loan repayment.

5 cons of 529 plans for college

Here are five potential disadvantages of 529 plans that might affect your savings choice.

1. There are significant upfront costs

The initial costs of starting a 529 plan depend on the type of account.

  • Prepaid tuition plan: You’re paying for college credits out of pocket and in advance. In Florida, for example, costs start at $180.51 per month to prepay tuition at one of the state’s dozen public universities, and that still wouldn’t cover living expenses.
  • Savings plans: Although these are more affordable options, some have minimum contribution requirements. In Arkansas, for example, you’d need to make an initial contribution of at least $500 to open an iShares 529 Plan. Some states even require an initial deposit of at least $1,000.

In most states, you might also be required to make minimum subsequent contributions between $10 and $50 each month.

2. Your child’s need-based aid could be reduced

If you start a 529 plan for your child, you should know that it could affect their access to federal student aid.

That’s because your family’s full financial picture is considered when you and your student complete the Free Application for Federal Student Aid (FAFSA). Your 529 savings could increase your student’s Expected Family Contribution (EFC), which is calculated using the FAFSA.

The EFC is the Department of Education’s way of estimating how much you can afford when paying for college. The higher your EFC, the fewer federal grants, work-study opportunities, and subsidized loans your child could receive. (If you’re planning ahead for your child’s college options, keep in mind that EFC will be replaced by Student Aid Index, or SAI, for the 2023-2024 school year.)

If the savings plan is under your name (not your student’s), you could lessen this con of 529 plans. After all, removing an asset previously assigned to your son or daughter could give them greater access to need-based assistance, depending on their school’s financial aid formula.

3. There are penalties for noneducational withdrawals

Of all the cons of 529 plans, this one is the easiest to avoid: If you don’t use a 529 plan for ineligible expenses, such as transportation to school or dorm room decorating, you can skip the penalties.

Remember that if you make a withdrawal to cover an ineligible expense, it’ll be considered income. The IRS will tax you on it. Plus, you’ll be subject to a 10% fee.

4. There are also penalties for ill-timed withdrawals

You might know you have a tuition bill coming down the pike and withdraw the amount from your savings plan without a second thought.

But think twice. A qualified education expense should occur during the same year of the withdrawal. To be safe, talk with your 529 plan provider before making a withdrawal for a seemingly approved expense.

Also, be aware that if you withdraw more than $14,000 in a year to pay for tuition, that could subject you to the IRS gift tax.

5. You have less say over your investments

When you sign up for a savings plan, you’re really signing up with the plan manager selected by your state. Financial services company TIAA, for example, manages 529 plans in seven states.

If you’re a savvy investor, you might be disappointed by the lack of control you or your family financial advisor could have in managing the plan. You can only change how you’re allocating your plan’s balance up to two times per year, for example.

In this set-it-and-forget-it format, you also must choose from preset investment options. In Oregon, for example, one portfolio makes investments based on your student’s age. The closer your student is to college, the more conservative the portfolio becomes.

But unless you’re a beginner investor, you might miss having up-to-the-minute flexibility in where you’re investing your money. That’s certainly among the potential cons of 529 plans.

Weigh the pros and cons of 529 plans

Sure, there are both advantages and disadvantages of 529 plans. At their core, however, 529 prepaid tuition and savings plans give families a leg up in paying for college.

With a prepaid tuition plan, you can lock in today’s tuition rates even if your student is a decade or longer from enrolling. And with a more traditional savings plan, you can access stock market growth with small monthly contributions.

Weigh the pros and cons and review your family situation to make the most of a 529 plan.

Even if a 529 plan sounds like the perfect solution, examine alternative ways to save for college. Whichever savings vehicle puts you and your future college student in the best position is the one you should choose.

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