Pros and Cons of 529 Plans. Does Your Child Really Need One?

Are you considering starting a college savings plan for your children? As a parent, it’s important to understand the advantages and disadvantages any financial decision you make for your family. In this blog, we’ll be discussing the pros and cons of 529 plans and whether or not your child needs one. Read on to learn more about this popular college savings option and decide if it’s the right choice for you and your family.

Answering All Your Questions on 529 Savings Accounts

It is hard to write a compelling article on an account that was named after a three-digit number in the tax code. Snore.

At the very least they should have given it a better name. Perhaps the “Genius Fund.”

Then people would be interested.

As it stands, only an estimated 18% of kids have a 529 account. It seems like that could go up to 25% with a better name.

On the flip side, when your child says they have a 529 account they’ll likely feel very grown-up.

So let’s delve into the pros and cons of 529 plans, we’ll expose you to the good, the bad and the ugly of these elusive accounts. In the end, you’ll know whether one would work for your family.

What is a 529 Account?

Back in the 1990’s New Kids on the Block were rocking the airwaves, fanny packs were a fashion statement, and the state of Michigan was feuding with the IRS over the tax-exempt status of its prepaid tuition plan. Michigan ultimately prevailed which led to a bipartisan effort to create federal tax relief for vehicles of college savings, and 529 accounts were born.

The government wants us to save for our kids’ education, and when the government wants us to do something, they generally use tax breaks to encourage it. The truth is, we really should do it anyway, so there are very few reasons not to take advantage of the benefits offered by 529 plans.

Most people invest in a 529 account for its tax savings.

A 529 is an investment account – more akin to a mutual fund than a savings account.

Simply put, you won’t pay taxes on 529 plan earnings as long as they are used for a qualified educational expense.

What Educational Expenses Qualify?

There is a broad range of qualified expenses, including tuition for kindergarten through grad school, vocational school, some apprenticeship programs, room & board if the student is enrolled at least 50%, and even some books and computers.

If you start investing when a child is very young those taxes can add up to some serious savings.

What are the Pros and Cons of a 529 Account?

PRO 1: FAFSA Benefit

In addition to saving on federal income tax savings, another popular 529 benefit is that the holdings count as parental assets, not the student’s assets, on the FAFSA (free application for federal student aid). This matters because student assets are weighed more heavily (up to 20%, as opposed to up to 5.64% for parents) when determining the family’s expected contribution.

PRO 2: Different 529 Benefits in Each State

Different states offer varying 529 plans with specific benefits. The College Savings Plans Network provides a comprehensive comparison tool to shop 529 plans and choose one which is right for you.

Given the benefits, a 529 account seems like a no-brainer for your child. However, there are drawbacks.

CON 1: You May Be Required to Pay Taxes and Fees on 529 Earnings

The most noteworthy is that if you do not use the money for a qualified expense you will have to pay the taxes and fees (10% to the feds and possibly more to the state, on top of college).

While these penalties aren’t insignificant, it’s certainly worth taking a deeper dive into why you wouldn’t use the money for its intended purpose. If you’re counting on scholarships for your Einstein-level child, they can use funds for room and board, books and their computer.

If that’s not necessary, you may withdraw the exact same amount as the scholarship penalty-free, with the caveat that you will have to pay the normal rate of taxes. If your little one is already dead set on a career that doesn’t include higher education, chances are that their trajectory will include trade or vocational school which would be a covered educational expense.

The bottom line is that it’s hard to find an article out there that argues against opening a 529 account. In the vast majority of cases, the benefits far outweigh the drawbacks.

Real Life Story: The Housecleaner and the 529 Plan

A friend who is a housecleaner recently told me about her first job working for a financial planner, who explained the benefits of 529 plans to her. She only made $40 cleaning the house that day, but that financial planner helped her set up plans for her daughters. Her first is about to graduate from college debt-free.

We have compiled a list of commonly asked questions below. In addition, the Securities and Exchange Commission offers helpful resources if you’re ready to get the ball rolling. Talk to your account or a certified financial professional to make sure it is the right fit for your particular situation. If a 529 is right for your family, start sooner rather than later so that your child can watch their means rise to the level of their potential.

529 College Savings Plans FAQs

Codes and Rules can change and are subject to interpretation. Before investing or relying on this information, talk to a Certified Financial Planner.

Can you open a 529 Plan for a baby before they are born?

Not Exactly. The IRS requires a living beneficiary for a 529 account, so you cannot open the account in the name of your unborn child (even if your child has a name). However, you can open one for yourself and transfer it to the child once they are born. See below: Can you transfer 529 accounts?

Can you transfer 529 accounts?

Yes, you can transfer funds in a 529 account from one beneficiary to another, if they qualify as a family member of the original beneficiary. And, as of 2024, unused 529 funds – up to $35,000 – can be carried over into the beneficiary’s Roth IRA with no penalty. However, rollover funds are subject to annual Roth IRA contribution limits ($6,500 in 2023), and the 529 account must have been open for at least 15 years and contributions made in the last five years cannot be transferred.

Who qualifies as a family member of the beneficiary of a 529 account?

Natural or legally adopted children, parents or ancestors of parents, siblings or step-siblings, step-children, step-parents, first cousins, nieces/nephews, and aunts/uncles are all qualified beneficiaries of your 529 account. The spouse of the beneficiary and the spouse of any previously listed family members also qualify. Any of these family members are eligible to be named beneficiary of a 529 account if you want to transfer an account from one person to another.

What are the exact tax benefits?

There are several tax benefits to 529 accounts.

Federal Tax-Free Earnings: Money in a 529 account will grow tax-free when it is used for a qualified educational expense.

State-Specific Tax Breaks: Different states offer different tax benefits, including deductions, incentives and grants. Some states only offer these benefits if you enroll in a state-specific 529 plan, while others offer for all plans. A good rule of thumb is to start with your state, and then look around and see how other plans compare. This is a great resource for state-specific benefits.

Contributions are not deductible, but earnings in a 529 plan will grow federal tax-free and when earnings are taken out to pay for college they will also not be taxed. Up to $10k in tuition expenses can be withdrawn tax-free. Depending on what state you live in, your state could offer tax breaks (either full or partial). Check if your state takes part in these tax breaks.

Another one of the benefits is that there are high contribution limits with no annual contribution limit, which helps maximize tax benefits.

What is the full list of qualified education expenses that the money can be used for?

It is a common misconception that 529 funds can only be spent on tuition, but there is actually a myriad of other educational expenses which count as qualified educational expenses. The list includes tuition and fees, books, computer technology (related equipment and internet access), special needs equipment, room and board if the student is enrolled 50% of the time, up to $10k in K-12 tuition expenses (per year, per beneficiary), up to $10k in student loan payments (lifetime limit), and the costs of apprenticeship programs.

Can the money be used for graduate school if there is some left over from the child’s time in college?

Yes! 529 funds can be used for graduate school.

What happens if you withdraw 529 funds for a non-qualified purchase?

If a withdrawal is made for a non-qualified expense, it is subject to a 10% withdrawal penalty and you have to pay income taxes you could have otherwise avoided, but in some scenarios, the 10% withdrawal penalty will be waived.

These scenarios include if the beneficiary dies or becomes disabled, if they receive a tax-free scholarship, if they receive educational assistance through a qualifying employer, if they attend a U.S. Military Academy, or if the qualified education expenses are used to generate the American Opportunity Tax Credit (AOTC) or the Lifetime Learning Tax Credit (LLTC).

Citation: Saving For College

Does opening a 529 account in one state and then going to college in another affect how it is used?

When opening a state-sponsored 529 plan both plans are available: the savings program and the prepaid programs allow you to use your 529 accounts at out-of-state colleges and universities. With the savings program, the full value of your 529 accounts can be used at any eligible college/university (even some international universities). With the prepaid program, the 529 can be used in full for in-state tuition and can be transferred to private or out-of-state institutions, although the full value of your 529 may not be usable depending on the state.

There is also the private college 529 plan, which specifically allows you to use 529 funds at private colleges across the country. It specifically helps you save on these private colleges by locking the current tuition and fee rates. This is not a state-sponsored program. It is sponsored by the non-profit membership organization Tuition Plan Consortium LLC (TPC). Find out if your institution is 529 eligible.

What are the differences between a 529 Prepaid Tuition Plan and a 529 College Savings Plan?

The key difference is that when using the PrePaid Tuition Plan, your money goes toward paying a set tuition rate, while the College Savings Plan operates as an investment plan, where your contributions grow over time and then can be withdrawn and put towards any educational expense.

529 College Savings Plan
-Doesn’t take current tuition rates into account
-Several investment choices
-Available in every state + DC
-Can be used for any educational expenses like room, board, and books
-No residency requirements (can be opened in any state)
-No time limits (recipient must be a living, named beneficiary)
-More flexibility if the beneficiary doesn’t use

529 PrePaid Tuition Plan
-Locks in current tuition rates
-No investment choices
-Available in 8 states + Private College Plan
-Cannot be used for room and board
-Residency requirements
-Time limits (contributions stop at 18 and must be used by 30)
-Balance can be transferred to another school, but less flexibility to transfer and less return

What if my child does not need their 529 because they get a scholarship or they do not attend college?

If your child does not need to use their entire 529 account because they receive a scholarship, you are able to withdraw the amount equivalent to the scholarship penalty-free, but it will be taxed.

If they do not use it because they do not go to college, you can withdraw the money in the account for a “nonqualified” distribution (your earnings in the account, but not the contribution amount, would be subject to state and federal tax plus the 10% federal tax penalty for withdrawing for a “nonqualified” withdrawal).

However, there are other options. You could change the beneficiary of the 529 to another family member who will use it. Another option is to defer its use and keep the savings in the account.

Do contributions to a 529 plan count towards my annual gift tax exclusion?

Yes, but you can supercharge a contribution and give up to 5 years’ worth of gift tax exclusion funds ($85k individually or $150k jointly) in one year as long as you set up a 5-year election. As of 2023, each parent may gift up to $17,000 per beneficiary. Any access amount will “count against your lifetime estate and gift tax exemption and will have to be reported on Form 709 when you file your taxes.”

When can I open a 529 account for my child? Is it ever too late to do so?

You can open a 529 account at any age and it is never too late to open one and start saving.

How do I open a 529 account?

It is recommended to first search for and compare the plans in your state (if there are multiple available). The College Savings Plan Network provides information that you can select to compare and links to state-specific 529 plans. The most common way of opening a plan once you’ve selected one is by selecting a “Direct Sold” plan, which offers residents to open and invest in the plan directly with the state at a low fee and without sales commission. The second type of 529 plan you can select is called the “Advisor Sold” plan, which means you receive professional advice on investing in a 529. This plan includes standard sales commissions.

Who controls investments once a 529 account is opened?

You/the account owner control investments. Many states use contracted investment managers to assist the state in investment portfolios and help investors meet their college savings goals, but they do not have direct control over your specific investments.

Who can contribute to a 529 account?

Typically, anyone can contribute. Check your specific 529 plan to see if there are any restrictions, as some plans only give tax benefits for investing to contributors who are named as the account holder.

If you open a 529 in one state, can you move your investments to a 529 in another state?

Yes, you can move funds from a 529 account in one state to a 529 account in another one time per 12-months.

Can you change investment options once you have opened an account?

Yes, you can change investment options twice a calendar year or if you change the beneficiary to a family member of the current beneficiary. Every time a new contribution is made to the account, you can select a new/different investment option for the new contribution or for future contributions for the plan.

Conclusion: Saving is not Reserved for the Wealthy

College and financial success is not only for children who come from money. We have to realize that we can give these gifts to our children, regardless of our income or position. 529s are a great place to start.

In conclusion, 529 plans are a great option for families to start saving for their children’s college education, as they offer a range of benefits. These include tax-free growth, investment flexibility, and the ability to withdraw funds for qualified higher education expenses. However, it’s important to understand the risks of investing in a 529 plan, such as the potential for market volatility, and to make sure the plan is right for your family. With the right research and guidance, 529 plans can be a great way to save for your child’s college tuition and prepare them for the future.

By understanding the pros and cons of 529 plans, you can make an informed decision on whether this college savings option is right for you and your family.