What are the pros and cons of 529 plans?
529 plans are tax-advantaged investment accounts with the purpose of saving and paying for college.
It’s probably no surprise, but college costs are only becoming more expensive as the years pass. For any parent trying to save up for their child’s education, it can become overwhelming to consider all the avenues available and select the best option that will suit you and your family.
And while student loans will always be an option available for your child to attend school, keeping them out of debt as they become a young adult is likely a priority of yours.
One of the main ways parents choose to save up for their child’s college education throughout the years is to invest in a 529 college savings plan. To give you a better idea of whether this is the right choice, let’s take a deeper look into what this plan is, how it works, and discuss some of the benefits and drawbacks of taking this route.
What is a 529 Plan?
Before we further discuss the pros and cons of 529 college savings plans, let’s cover what this type of account is in the first place.
A 529 plan is an investment account that provides federal and state tax benefits when the funds are used to pay for qualified educational expenses by the account holder or any beneficiaries. A 529 plan can be used to pay for college expenses, K-12 tuition, student loan repayments, and apprenticeship programs.
As we noted above, this is a common way that parents will save up for their children’s college education, so continue reading as we cover some of the greatest benefits of investing in a 529 college savings plan.
Pros of 529 College Savings Plans
Now we can describe some advantages of using the best 529 plans.
Tax Benefits
529 plans are preferred for the tax benefits they provide account holders. The deposits made into a 529 plan grow on a tax-deferred basis, and distributions are made tax-free when used for a qualified education expense.
What constitutes a qualified education expense? Namely, this includes tuition and fees, books and supplies, room and board costs, up to a certain limit in K-12 yearly tuition, and student loan repayments.
Above all, it’s important to note that 529 plans are the only college savings plans that provide tax benefits at the state level. Most of the time, states will exclude 529 qualified plan distributions from taxable income.
Convenience
In addition to the tax benefits, 529 college savings plans are also low maintenance for account holders and can be opened up online or with the help of a financial advisor. In this case, the plan administrator takes care of the account’s ongoing management, and the account holder doesn’t have to concern themselves with the investment details of the plan.
Flexibility
Another great benefit of 529 college savings plans is that they are very flexible regarding who can use the funds for their education and what types of institutions the funds can be used at. Families can invest in nearly all of the best 529 plans wherever they live, no matter where their child chooses to attend school.
High Contribution Limits
The high contribution limits afforded to 529 plans can also be a large advantage compared to other saving options, allowing contributors to generate large tax savings.
There are no annual contribution limits to 529 college savings plans and a high aggregate contribution limit. These will vary state by state, but in most cases, these limits are between $200,000-$500,000.
This is because 529 plan contributions are considered gifts to the noted beneficiary. Each year, there is a maximum limit on the amount of contributions that can qualify for the gift tax exclusion, which is $16,000 in 2022.
In addition, there is an option to donate up to $80,000 in one year without being treated as a taxable gift because it can be accounted for as if it were spread over five years.
Minimal Impact on Financial Aid
Lastly, 529 plans are treated favorably by financial aid, resulting in minimal impact on the student’s eligibility for this funding. This is because the account is listed as the asset of the parent rather than of the student, plus the distributions from the account are not treated as income on FAFSA when the account is owned by the parent or the student.
Cons of 529 College Savings Plans
With a better idea of the advantages of 529 college savings plans, we can now discuss some of the drawbacks that families should be aware of.
Penalties for Certain Withdrawals
As we discussed above, withdrawals from a 529 college savings plan are made tax-free when they’re used to fund qualifying educational expenses. Therefore, account holders will incur penalties when they withdraw funds for other uses and pay income tax on the earnings portion.
There are still some exceptions to this rule, including if the beneficiary gets a scholarship, attends a U.S. Military Academy, becomes disabled, or dies.
Limited Investment Choices
Another aspect of 529 college savings plans that may be a disadvantage for some is that there are minimal investment choices. Account holders must select from a menu of investment options that the plan administrator offers, usually static investment portfolios that target specific levels of risk.
These portfolios are often age-based and are programmed to shift asset allocation the closer the beneficiary gets to college age for optimal results.
Thus, for any account holder who wants more control and flexibility with where their money goes and what specific investments they can make, a 529 plan may not be the best choice.
Fees
Additionally, account holders will pay fees for managing their 529 plan. This means they are paying a good amount of money towards the plan that won’t go toward college savings.
It’s important to note that fees will vary between 529 plans, so it’s important for parents to do their research beforehand to see which plan will be the best deal regarding the fee structure while still helping them reach their college savings goals.
Ownership
With 529 college savings plans, the account owner will have full legal control over the money in the account, not the beneficiary. This means that the account holder can change who the beneficiaries are at any time, take non-qualified distributions as they please, or completely close and liquidate the account.
This may not be a problem for certain families, but others who are relying on a grandparent’s 529 account or one from a different relative may not like this lack of control they have over the plan.
State Income Tax Recapture
It’s also important to point out that if you roll over a 529 plan to another state’s 529 plan, any state income tax deductions or credits that the account holder previously claimed may be subject to recapture. Plus, the earnings portion of the rollover may be considered taxable income by the state. So, this is something to keep in mind.
Final Thoughts: Is a 529 College Savings Plan Right for My Family?
As you can see, there are many pros and cons associated with 529 college savings plans. And while they can be a good option for many families when it comes to saving for college, parents should still consider all the advantages and disadvantages of these plans to make the right choice.
Namely, parents should consider if they plan to use the funds exclusively for education savings, given the penalties and tax implications that will occur when the funds are used for non-qualifying expenses. Therefore, you should make a good assessment of your child’s educational expenses needs and try to plan accordingly to avoid penalties.
Even still, the tax benefits and limited impact on financial aid mean that 529 plans can be a great tool to use when saving for your children to attend college. Plus, many states may offer additional state tax benefits, which can be an added bonus to account holders.
If investing in a 529 plan sounds like the right option, consider meeting with a financial advisor who can help guide you in the right direction and find a plan that works for you and your family’s needs. Schedule a call with us today to get started on your college savings journey–you don’t want to delay this any longer.