If you’re interested in saving for your child’s college education, you’ve probably heard of the 529 plan. Many parents and families choose it as their college savings vehicle because it’s so well known, but it is not the only option.
It’s important to consider all the aspects of a 529 plan. Just like with any investment, you don’t want to go into it blindly. You should consider the pros and cons, as well as other alternatives that may be a better fit.
Take time to do your research and select a college savings account that makes the most sense for you and your family.
We’ll touch upon the basics of 529 plans, the downsides to them, what you should be considering when deciding where to save for college, and other plans that might be a better fit for your needs.
What Are 529 Plans?
A 529 plan is a state sponsored tax-advantaged investment vehicle specifically for the use of funding your child’s higher education. As long as the funds are withdrawn for expenses relating to college, withdrawals are not taxed.
529 plans come in two variations: a savings plan and a prepaid plan.
The prepaid plan allows you to buy at tuition at today’s rates. Why is that a good thing? College tuition is currently rising 8% each year. That’s much higher than the rate of overall inflation, and it’s possible that your investments won’t keep up with rising costs. Prepaid plans essentially take the risk element out of it in an effort to guarantee growth of the value of your account.
The savings plan, on the other hand, has families and parents investing in mutual funds. The growth of your contributions is subject to market fluctuations, just like any other investment. We’ll touch upon this later but the savings plan allows for greater flexibility than the prepaid plan.
What Are the Drawbacks of 529 Plans?
It’s important to be aware of the potential pitfalls of 529 plans. Ensure you read the fine print before making an investment, and don’t feel like a 529 plan is your only option.
Here are some of the biggest negatives inherent with 529 plans:
- 529 plans vary by state, meaning that the benefits can differ vastly from plan to plan. Boston MA residents may not have the same options as New Hampshire residents, because these are state-run savings vehicles. It’s best to check with your state before jumping in.
- You must actively invest the savings. You’ll need to do your research to choose your own funds, which can be complicated and overwhelming for many families. You can only adjust your portfolio once a year.
- As previously mentioned, tuition is on the rise faster than inflation can account for, which puts even more pressure on parents to choose the right funds.
Some 529 plans come with fees that subtract from the total value of the account.
- Prepaid plans are restricted in that they are typically used for in-state public universities, though you may be able to get partial value at private schools or out-of-state colleges. You also have no control over how the money is invested.
- You should make sure that prepaid plans are guaranteed by the state. Some plans have closed due to lack of funds, as they simply can’t keep up with inflation.
When it comes time to actually withdraw money from the account, you need to be careful to get the amount right. Make sure to only take out exactly what your child needs to pay for tuition and other college expenses after receiving other forms of aid. If you take out too much, you could face penalties on the remainder.
Additionally, if you withdraw the funds for other uses besides higher education, you’ll face a 10% penalty, and you’ll incur taxes on any earnings.
How to Determine if a 529 Plan is the Best Option for College Savings
All that said, there is a reason that 529 plans are the most popular way to save for college. Let’s take a look at why it might be the right decision for you.
One of the biggest pluses about these plans is that they do offer some flexibility. In the case that your child or family member that the account was originally for does not attend college, other beneficiaries in your family can use the funds. Transferring to another family member (according to IRS guidelines) doesn’t incur any tax, and might alleviate any worry you have about the money “going to waste.”
Or, if you feel confident that your child will attend college and will attend a specific school, a prepaid 529 plan might not be a bad idea. This allows you to “lock in” today’s tuition rates even though they’ll surely be exponentially higher in the future. However, I caution this idea because no one can be confident on what decisions their child will make 18 years down the road.
If your income is on the higher side, a 529 plan might be the best decision for you, as well. Other alternatives have income restrictions. Depending on your state, the tax advantages might also negate the fees incurred with a 529 plan.
And if you’re responsible with credit cards, you could also enroll in one of many rebate/cash back programs that will help to fund a 529 plan. This is a small but notable perk. It serves as a unique way to earn more without much effort.
Other Options for College Savings Vehicles
Don’t feel tied in to the 529 plan. Depending on your state, choosing a different route may be the best option for you.
A Coverdell Education Savings Account is similar to a 529, but you can use the funds for any education expense (K-12), not just college. It also offers more investment choices than a 529.
However, the major downside is that there is a $2,000 yearly contribution cap. The additional drawback here is that depending on your income, you might not be able to contribute. The workaround is to gift the money to the child, who can then open an account in their name.
If the funds are not used by the time the beneficiary turns 30, the earnings will be taxed as income and you’ll face a 10% penalty. To avoid this, you can transfer the funds to another relative, just as 529 plans allow you to do.
Another option is a Uniform Transfer to Minors Act (UTMA), which is also a custodial account. It’s not specifically for college savings; anyone can contribute, but once the beneficiary reaches either 18 or 21 (it differs by state), they are free to use the money however they wish. They are not limited to using it solely on college expenses.
The one downside to this plan is that it can have an adverse impact on the amount of financial aid a student is eligible for. Since the account is in the minor’s name, it will count as an asset for them.
Alternatively, you could combine several savings vehicles. It’s not a bad idea to go for the best of both worlds approach and open both a Coverdell and a 529 plan. There are a lot of options out there, it’s just a matter of finding one that suits your needs the most.
Get Started Sooner Rather Than Later
It’s worth stating that either way you fund your child’s or family member’s education, you’re still taking action. That’s much better than not saving — or letting the money sit in a bank account, accruing next to no interest.
If you find you’ve made a mistake, or the investment you initially went with doesn’t make sense for you anymore, you can always switch. Most plans allow for rollovers without penalties. The important thing is to do your own research, call around to get state-specific information, and make an informed decision.