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The Biggest Pros and Cons of 529 Plans for College

A 529 plan is a tax-advantaged investment account designed to provide families with an easy and affordable way to save for college. These savings plans grow tax-free and allow for tax-free withdrawals when used for qualified education expenses.

There are a variety of smart ways to save and pay for college, but 529 plans continue to grow in popularity. According to the College Savings Plans Network, there were over 14.56 million 529 savings accounts nationwide as of June 2020.

529 plans at a glance

Here are some of the main pros and cons of 529 plans, and some alternative investment tools to consider.

Benefits of 529 Plans

Cons of 529 Plans

Tax-free growth and withdrawals

Funds are limited to qualified education expenses

State tax deduction or credit (depending on state)

Tax penalty for non-education withdrawals

Low minimums to open an account

Not all states offer a tax benefit

No income limits or restrictions based on age

Fees vary from plan to plan

High contribution limits

Limited options if your child doesn’t go to college

Flexibility to change beneficiaries

Contributions might be subject to federal gift tax

Parent-owned plans have minimal effect on financial aid eligibility

Third-party ownership (e.g. grandparents) could reduce financial aid eligibility

Advantages of a 529 plan

529 college savings plans have many perks that can benefit both the contributor and the beneficiary.

Here’s some of the advantages of a 529 plan to save for education expenses.

You can take advantage of federal tax-free growth and withdrawals

One of the biggest benefits of a 529 plan is that your investments grow free from federal income tax. And, when used for qualified education expenses, the funds can be withdrawn tax-free.

As of 2020, qualified higher education expenses are “expenses related to enrollment or attendance at an eligible postsecondary school”. This includes expenses like tuition, fees, books, supplies and education-related equipment (e.g. laptop).

Additionally, up to $10,000 can be used tax-free per year on qualified elementary and secondary education (K-12) tuition expenses. And up to $10,000 (lifetime limit) of your 529 plan savings can be used to pay back student loans in the beneficiary’s name — or loans under their sibling’s name (e.g. brother, sister, stepbrother or stepsister).

Your state might provide a tax deduction or credit on state income taxes

Some states provide tax deductions or credits to their taxpayers in exchange for contributing to the state’s 529 plan.

These 529 plan tax benefits vary greatly by state, ranging from no incentive at all to being 100% tax-deductible.

A 529 account can be opened online with very little investment

A 529 account can easily be opened and managed online. Most plans have low minimums to open an account. For example, college savings plans in Texas, Oregon and Washington can be opened for as little as $25.

You can choose to set up recurring contributions from your bank account or payroll if your employer supports it. This makes saving for college convenient and easy.

There are no income limits or age restrictions

529 plans are available to anyone, regardless of the account owner’s or contributor’s income. And, as a general rule, there’s no age restriction for the beneficiary.

But each state plan sets their own requirements, so you’ll need to check with your plan to see if there are any penalties or limitations on making withdrawals before the account is a certain age.

You can maximize your savings with high contribution limits

Unlike other investment tools, there isn’t a federal or state annual contribution limit for 529 plans. But each plan will have a maximum aggregate limit for each beneficiary.

High contribution limits allow you to adequately save for college, with current maximums ranging from $235,000 to over $500,000.

You can change beneficiaries, if needed

529 plans provide flexibility if you want to transfer money to another beneficiary. This is a huge benefit in a scenario where a child no longer needs access to funds for education expenses.

Let’s say your first-born child no longer plans to attend college or they receive a scholarship that covers their cost of college. Since they no longer need that money, you can easily change the beneficiary to another child’s name and continue to reap the benefits of a 529 plan.

Your account has minimal effect on your child’s financial aid eligibility

Any funds in a 529 plan owned by a parent or dependent student are considered parental assets when completing the Free Application for Federal Student Aid (FAFSA). And parental assets receive favorable financial aid treatment when calculating the Expected Family Contribution (EFC) to determine the student’s financial need.

A maximum rate of 5.64% is used for parental assets in the EFC calculator. Whereas student assets are calculated at 20%.

This is a significant 529 plan benefit because the higher your EFC, the less financial aid you’ll receive.

Potential disadvantages of 529 plans

529 plans are a great way to save for college, but they come with some drawbacks that could cost you in the end.

Here’s some potential 529 disadvantages to consider.

Funds must be used on qualified education expenses or you’ll pay the price

Your 529 investments grow on a tax-deferred basis, which means your earnings will become subject to income tax and a 10% penalty if withdrawals are used for non-qualified education expenses.

But there are exceptions to the penalty (not the income tax), which include scenarios such as the designated beneficiary receiving a scholarship or becoming disabled.

Not all states offer additional tax benefits

States like Alaska and Nevada don’t have a personal income tax, so no additional state tax deduction or credit is offered for contributing to their 529 plan. And other states like Kentucky and Maine simply don’t offer additional tax benefits even though they do impose a state personal income tax.

Fees vary by 529 savings plan

Depending on your state’s plan, you might run into a variety of plan fees. This might include fees for enrollment, annual maintenance or other operating expenses.

Be sure to research your state’s 529 plan fees and compare them to other investment options.

You might have limited options if your child doesn’t go to college

If your child decides not to go to college, you have options for how to use your 529 funds. But they’re limited.

As mentioned, you can change the beneficiary to another child. But what happens if you don’t have any other qualifying family members to pass the funds to?

One option is to leave the contributions invested in the account. And the only other option is withdrawing the money for a non-qualified distribution and incur the 10% tax penalty.

Contributions might be taxable under the federal gift tax provision

Depending on how much you contribute, your 529 plan contributions might be subject to the federal gift tax.

Fortunately, you can claim an annual gift tax exclusion up to $15,000 per beneficiary. And, if you’re married, you and your spouse can claim this exclusion, separately — totaling up to $30,000.

Third-party ownership might affect financial aid

A 529 plan won’t significantly hurt the student’s financial aid eligibility when it’s owned by the parent. But distributions from a third-party 529 plan, say from grandparents, are treated as untaxed income for the beneficiary.

Third-party distributions can reduce a student’s eligibility for financial aid. So, it’s important families take steps to minimize the effect. One way is to strategically time distributions (e.g. wait until their senior year of college), so they aren’t included in the FAFSA calculations for award years where financial aid is needed.

Are 529 plans worth it?

There are many pros and cons of 529 plans, so it’s important to explore other options for saving for college to find the right fit for your family.

Common alternatives include:

  • Uniform Gifts to Minor Act (UGMA) or Uniform Transfers to Minors Act (UTMA) custodial accounts. These custodial accounts allow for the money to be spent on anything as long as it benefits the minor. Unlike a 529 plan, UGMA and UTMA investments are taxable and considered a student asset on the FAFSA, which can adversely affect their financial aid eligibility.
  • Coverdell Education Savings Account (ESA). Similar to a 529 plan, an ESA lets you take advantage of tax-free withdrawals for qualifying education expenses. But you can only invest $2,000 per beneficiary each year. And the account will be subject to certain age and income restrictions. This includes only being allowed to make contributions before the beneficiary turns 18, unless it’s for a special needs beneficiary.

Each type of investment has its advantages. But 529 plans offer great tax benefits and will have minimum impact on your child’s financial aid eligibility in the future.

If you’re looking for a low maintenance investment option to save for college, 529 plans are worth exploring.

Keep in mind that most 529 plans don’t have a state residency requirement, so you aren’t only limited to your state’s plan. But depending on where you live, you might not be able to claim state tax benefits if you choose an out-of-state 529 plan.

So, be sure to weigh each plan’s fees, investment options and any other benefits or restrictions to find the best 529 plan for you.

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