Weighing The Pros and Cons of 529 Plans

College is expensive. As I anticipate the arrival of my daughter later this year, I’ve been thinking more and more about how to help my first child avoid the student loan mess I had to deal with. A 529 savings plan isn’t the only way to save for a child’s―or a grandchild’s―college education, but these pros and cons might help your family choose the best vehicle for your college savings.

Pros of 529 college savings plans

A 529 plan is a flexible, tax-advantaged way to save for your child’s education expenses. Here are a few advantages to consider.

1. Federal tax advantages: tax-free growth

A 529 plan is somewhat similar to a 401(k) in that growth on investments is not treated as taxable income. But unlike a 401(k), you will never pay taxes on a withdrawal as long as the money is used for qualified educational expenses. In addition, 529 contributions are not deductible from your income. Tax-free growth means that the earlier you open a 529, the greater the tax benefit you’ll eventually receive.

Contributions to a 529 plan are treated as completed gifts and are therefore subject to the federal gift tax. An annual exclusion applies for each beneficiary ($15,000 in 2021), so you can contribute up to $15,000 to a 529 savings plan for each beneficiary. If you are married, you and your spouse can each contribute $15,000 without having to pay the gift tax. If you want to make a large lump sum contribution, you can elect to treat that contribution as if it were spread over five years, up to $75,000. You could make a $50,000 contribution in 2021 and elect to apply it as $10,000 per year over the next five years, thus leaving $5,000 in annual gift tax exclusion available for use.

2. Flexibility in selecting a plan type

There are two types of 529 plans: prepaid tuition plans and education savings plans.

• Prepaid tuition plan – This type of 529 allows the investor to purchase future higher education credits at today’s prices. In essence, this is a bet that college tuition prices will continue to rise. A prepaid tuition plan isn’t guaranteed by the federal government, but some plans are guaranteed by state governments. In addition, this type of plan limits the beneficiary to attending a participating college or university. If the beneficiary attends a non-participating institution, the plan might pay less, thus yielding a potentially smaller return
• Education savings plan – This type of 529 plan is exactly what it sounds like: an investment account. The saver makes contributions to the plan and selects the investments. Withdrawals can then be used for any qualified educational expenses. A 529 education savings plan isn’t a savings account; it’s an investment account. Your balance has the potential, as with other investment accounts, to lose value in an economic downturn.  In general, this short article focuses on this type of 529 plan.

3. Choose whatever state’s plan works best for your family

529 savings plans are administered by the individual states, but that doesn’t mean you have to choose the plan administered by the state of either the saver or the beneficiary. Investors can shop around and choose the state’s plan that works best for their family. Keep in mind that some states offer generous state income tax incentives for residents (more on this below).

4. State tax benefits

Many states allow a state income tax deduction for 529 plan contributions. These deductions are often only available to the account owner if they are a resident of the state. Some states might even provide a tax credit for 529 plan contributions. For example, in my home state of Virginia, a 529 account owner can deduct contributions up to $4,000 per account, per year. This can be a strong incentive to choose your home state’s 529 plan instead of an out-of-state plan.

5. Use it for private K-12 education

It is most common to use 529 savings plans to pay for higher education costs like tuition, room and board, textbooks, and computer equipment. In fact, it wasn’t until the Tax Cuts and Jobs Act of 2017 that 529 plans could be used for anything other than college costs. Now you can use up to $10,000 per year from a 529 plan to pay for private or religious kindergarten through high school education.

6. Easily switch beneficiaries

What happens when your oldest child decides to skip college and join the Navy? As it turns out, this doesn’t leave you with a bunch of money in a 529 plan and no one to use it. You can easily switch the beneficiary to a younger child, a spouse, or even yourself. The funds can also be rolled into another 529 plan. The Secure Act of 2019 also allows you to use 529 savings to pay up to $10,000 toward another family member’s student loans.

7. High contribution limits

Aggregate contribution limits for 529 savings plans are set by the administering state. Unlike 401(k) or IRA accounts, 529 plans generally have very high aggregate contribution limits, ranging from $235,000 (Georgia) to $529,000 (California). Keep in mind that this is the aggregate limit, or the sum of all contributions over the life of the account. Although not necessarily a limit per se, gift tax considerations might limit the amount you want to contribute in any given year (see above).

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Cons of 529 college savings plans

1. Limited investment options

Much like an employer sponsored 401(k), when you start a 529 plan you’re really signing up with the state’s 529 manager. In some states you have a few different managers to choose from; in other states, there might be only one option. Each manager has its own rules about annual or aggregate contribution limits, investment choices, and fees.

Most 529 plans offer limited control over investments, even for your financial advisor. If you’re hands-on about your investments, it might be disappointing to find out that you’re stuck with a limited portfolio and can only make changes to your balance allocations twice per year. Virginia’s Invest529 plan, for example, offers a limited selection of portfolios, including Target Enrollment, Index, and Target Risk, among others. This set-it-and-forget-it strategy can be great for the novice investor, but might be frustrating to the more savvy investor who wants absolute flexibility and control over their portfolio.

2. Penalties for withdrawals used for non-qualified expenses

Using 529 withdrawals for non-qualified expenses incurs a double whammy of penalties. First and foremost, distributions used for non-qualified expenses are treated as income and taxed accordingly. Second, the IRS will hit you with a 10% tax penalty. All the more reason to make sure you stick to qualified education expenses like tuition, fees, textbooks, or computer equipment, and avoid non-qualified expenses like transportation, furniture, insurance, or amounts that exceed the school-determined cost of attendance.

3. Penalties for poorly timed withdrawals

Even if you’re using a withdrawal for a qualified expense, both the withdrawal and the expense should be in the same year. For example, you shouldn’t try to get ahead of the spring tuition payment by making a withdrawal in November. It’s best to talk to the plan manager before making any withdrawal just to be on the safe side.

4. Up-front costs and fees

Initial costs vary widely depending on the type of plan and the rules established by the plan manager. Some plans require a minimum investment of $500 (Arkansas) or more. Other states allow smaller monthly contributions on an automatic basis and may require continued minimum monthly contributions.

Fees on the investment portfolio eat into your earnings and reduce the overall tax benefit you eventually receive, as well as the ultimate balance available to the beneficiary. Do your research to make sure the fees charged by your plan fit your goals and investment strategy.

5. Potential to affect need-based federal student aid

Plans owned by a parent or dependent child are included as parental assets on the Free Application for Federal Student Aid (FAFSA). Although distributions from 529 plans aren’t counted as income, student financial aid is determined based on the student’s family’s overall financial picture. Significant savings in a 529 plan has the potential to increase the Expected Family Contribution (EFC), thereby reducing the student’s eligibility for federal need-based financial aid. If you’re planning for your child’s college education and federal student aid is a large part of the mix, it’s important to get a firm grasp on how a 529 plan might affect the EFC.

6. Ownership rules

Account owners have control over the funds within a 529 savings plan. The owner can change the beneficiary, make withdrawals, both qualified and non-qualified, or completely liquidate the plan. In most cases, when the account is owned by a parent or grandparent of the student, this probably won’t matter much. But it’s important to recognize who really has the power to control the account.

7. State income tax recapture

In some circumstances, you might want to roll over an existing 529 plan in State A to a new plan in State B. Any income tax deductions or credits taken in State A might be subject to recapture. Additionally, State A might treat the earnings on the rollover as taxable income.

Weigh the pros and cons to choose the best option

A 529 college savings plan is one of several options available for parents or grandparents to save for a child’s education costs. There are advantages and disadvantages to 529 plans. Prepaid tuition plans allow you to lock in today’s costs for tomorrow’s tuition, while an education savings plan allows you to invest small amounts today that can grow tax-free for your child’s education expenses tomorrow. Visit our 529 Plan Marketplace to look at plans offered by our trusted resources.

Pros:

• Federal tax advantages
• Flexibility in plan type
• Choose the best state plan for you
• State tax benefits
• Use for K-12 education
• Easily switch beneficiaries
• High contribution limits

Cons:

• Limited investment options
• Penalties for non-qualified expenses
• Penalties for poor timing
• Up-front costs and fees
• Need-based aid effects
• Ownership rules
• State income tax recapture

Carefully weigh these pros and cons against other education savings vehicles, such as a Coverdell Education Savings Account, to decide what’s best for your family and your financial planning strategy. I know I’ll be doing my research in the months leading up to the arrival of my daughter so I can put her in the best position possible for education success and financial stability.

Joshua Carrigan is a graduate of George Washington University Law School. Joshua spent eight years as a Nuclear Submarine Officer for the US Navy and is also a licensed skydiver. Four years ago Joshua and his wife embarked on a journey to become debt free, paying off $170,000 in student and car loans along the way.