A 529 plan is available in the United States. It is a tax-advantaged savings plan which encourages households to save for the future college costs of their children. They may be sponsored by educational institutions, state agencies, or state governments. Legally, this type of savings plan is called a “qualified tuition plan.”
These savings plans are called 529 plans because they are covered by Section 529 of the current Internal Revenue Code, as outlined by the U.S. Securities and Exchange Commission.
There are two types of 529 plans available, though not every state has both plan types authorized. Prepaid tuition plans, and college savings plans, can help to offset the costs of a future education.
Here are some of the pros and cons of 529 plans to think about if you’re concerned about the future costs of an education with your household budget.
List of the Pros of 529 Plans
1. For most people, withdrawals are tax-free.
To qualify for tax-free withdrawals, the money taken from the 529 plans must be used for a qualifying expense. That typically means tuition costs or associated schooling costs that are specifically listed by the state government, state agency, or oversight organization responsible for the plans. Because tax laws can change frequently, it is important to fully review what your current tax responsibilities would be before initiating a withdrawal.
2. Accounts earn interest to build wealth.
Unlike IRAs or 401k plans, the 529 plans are based more on mutual funds than they are direct investments. Most plans will invest the money you put into the plans through index management to ensure you receive some type of return. Some plans are different and may allow you to make direct investments. Others may give you different generic plans with which you can invest instead. You will always know where your money is going, though you may need to ask for the details before you agree to the 529 structure.
3. You can automatically contribute to a 529 plan.
Most 529 plans give you the option of having a portion of your paycheck taken out each month and placed within the plan. You get to choose how much money is withdrawn from your check every month into this savings plan. When this direct deposit feature is combined with the automatic investing that most plans offer, you have an easy way to grow the size of your plan to offset the growing costs of higher education.
4. There are no limits on contributions to some 529 plans.
If you have a college savings 529 plan, then you do not have a limitation on the amount you can contribute to it each year. Those with prepaid tuition 529 plans usually have a capped amount they can contribute, which is similar to the structure of an IRA.
5. The money saved in 529 plans is portable.
The 529 plan funds can be used toward the educational costs of any child within the household. The plans can be transferred to different family members as well, which means if one child decides not to go to college, the money can go to the tuition costs of another child. The funds aren’t forced to remain in your state either. You can use the money within the 529 plan to pay for the tuition cost of any college.
6. The funds stay under the control of the parent.
The owner of a 529 plan is the parent or guardian of the student who has been named as the beneficiary of the funds. The children cannot empty the account just because it is in their own name. That means there is a better chance that the funds being saved today will actually be used for college costs later on down the road.
7. There are gifting options.
Multiple family members can contribute to a 529 plan without worrying about gift taxes. There is a 5-year gifting feature on some plans which allows for up to $75,000 in contributions to be made without gift taxes being placed on the amount. In some states, these contributions may even qualify for a deduction against a state income tax, if present.
List of the Cons of 529 Plans
1. There are limitations on use for the money in a 529 plan.
If you don’t use the money for a qualified expense when withdrawing it from a 529 plan, then you’ll be hit with a 10% penalty on what you take out. The money taken out of the plan will also be counted as income for that year, which means you may be liable for state and federal income taxes on the amount as well. That is why it is important to review the current list of qualifying expenses before initiating a full withdrawal.
2. Excess money in a 529 plan is still subject to penalties and taxes.
Congratulations! You put three kids through college thanks to the 529 plan. Now you’ve got $35,000 in the plan… and no additional qualifying expenses. If you have leftover funds after paying for college costs, then you must withdraw the money. It will be subjected to penalties and taxation. In this example, the penalty would be $3,500 and then the income tax assigned would be based on the yearly income bracket for the household.
3. It could create financial aid difficulties for some students.
Financial aid is based on a student’s overall need for funding to achieve the level of education they desire. When a household has an active 529 plan, then it is counted as part of the assets that contribute to the overall financial picture of the student. Having a large 529 plan could reduce, or even eliminate, the possibility of receiving financial aid for some students, even if they are unable to cover their full tuition costs.
4. There are fewer investment choices for savvy investors.
Compared to other tax-advantaged savings programs, the 529 plan has few options available for households that are very experienced in investing. If you change your mind, then your options are the generic choices available within the plan, such as “conservative” or “aggressive.” If you find that mutual funds are outperforming your 529 plan and want to move your money, you’re stuck paying the 10% penalty and possible income taxes to move it.
The pros and cons of 529 plans show that there are unique opportunities for American households to offset the costs of college. By saving now, future costs can be potentially eliminated in a simple, hands-free way. This type of investment option may not be for everyone, however, and saving too much into a plan could have financial consequences of its own. That is why consulting with a qualified financial advisor before opening a 529 plan is always a good idea.