Does a 529 Plan Have Limitations?
College expenses continue to rise, but there are multiple ways to prepare for these future expenses. 529 plans have multiple benefits, but they also have a few notable drawbacks.
One of the biggest concerns potential college students have before pursuing higher education is the rising costs of college and the desire to graduate from college debt free.
There are multiple ways that students try to avoid taking on excessive loans, including 529 college savings plans. 529 plan accounts allow students or their families to start saving for college earlier with the money subjected to different taxing than a traditional savings account.
How Does a 529 Plan Work?
The biggest advantage of a 529 plan is that the invested money isn't subjected to state income tax, meaning that money can be saved at quicker rates.
The account holder can also withdraw the money tax-free for qualified education expenses. For education expenses to qualify for a 529, they must be for accredited educational institutions, which can include:
- K-12 education tuition
- trade or vocational school (including apprenticeship programs)
- undergraduate or graduate school
Although you can use the money for different types of education, 529 plans are most commonly used for college education costs.
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Types of 529 Plans
Multiple financial institutions offer 529 investment plans, but all are categorized as one of two types. Both investment accounts provide tax benefits and savings options to help pay for qualified higher education expenses.
Prepaid Tuition Plan
A prepaid tuition plan is a plan where a tuition rate for a college or university is locked in and a student or their family can begin paying off tuition expenses before classes begin. College expenses have increased year-over-year almost every year since 1971, meaning that locking in tuition rates now could save money in the long run as future tuition will likely be much higher.
Because prepaying for tuition involves advanced enrollment and allowing students to pay current rates for future education, not all schools allow or accept these plans.
Education Savings Plans
An education savings account is a plan that allows the account owner or donor, usually the student's family, to make tax-deferred contributions. In addition to tax-deferred payments, these plans aren't affected by federal income tax while growing or when withdrawals are made for qualified tuition programs.
Benefits of Investing in a 529 Plan
529 investment plans have many advantages for future students and their families.
Tax Advantages
One of the biggest incentives to invest in a 529 plan is the various tax advantages that they have. 529 plans aren't subjected to federal or state taxes, which allows for more rapid savings without the tax impacts that can come with savings accounts.
These plans also have a gift-tax exclusion beneath a certain amount. This allows for people who aren't the account owners to make contributions without having to pay taxes.
However, some state's plan requirements are different, so it's important to look into your home state's rules about eligibility before setting up a plan for yourself or a family member.
Diverse Investment Options
529 plans aren't just a savings account like you'd have at your bank or credit union. They invest your money (based on the account holder's decisions) into various investments, usually mutual funds. Before you set up a 529 plan, it's good to meet with a financial advisor to discuss distributions.
Beneficiary Flexibility
529 plans also provide flexibility in how the money is used. In addition to the multiple qualified tuition programs that 529 plans can be applied to, these plans can also help with student loan repayment.
Furthermore, beneficiaries can be changed among family members once per year. Over time, this will allow for funds to be allocated to family members as needed.
How Does a 529 Plan Compare to Other Savings Plans?
A 529 plan, both education savings and pre-paid tuition plans, is different from a bank savings account for a few reasons. 529 plans take the money invested and distribute it into a variety of investments, such as mutual funds, closer to a Roth IRA.
The investment objectives of a 529 plan change over time. 529 plans will become more conservative as the plan matures and withdrawal dates come closer.
Potential Drawbacks of 529 Plans
Although 529 plans can be helpful for a variety of reasons, there are still a few drawbacks that need to be considered.
One of the biggest concerns is how 529 plans can impact financial aid. Student aid eligibility is calculated based on the assets of the person applying. A 529 plan is considered an asset, even if it isn't subjected to taxes.
Although money can be withdrawn for any reason, there will be penalties for withdrawals that aren't for qualified tuition payments.
There are also limits on investment decisions and asset allocation for 529 plans, compared to an IRA or similar investment plan. To get a better understanding of these restrictions, talk to a financial advisor at the brokerage your 529 plan will be set through.
529 plans are tax-free, but they aren't without cost. In addition to the fees required to establish the plan, there are a variety of maintenance fees that can affect the overall cost of the savings.
What If I Don't Use My 529 Plan?
There is no expiration date for a 529, so even if you or your child don't attend college you might not want to withdraw the money immediately in case there is a change of heart.
Another option is to change the beneficiary to another family member who is pursuing higher education or vocational schooling.
Lastly, the money from a 529 plan can be withdrawn for non-educational reasons as long as taxes and penalty fees are paid.
What If I Make a Non-Educational Withdrawal from My 529 Savings Plan?
If you make a non-qualified withdrawal, there will be multiple taxes and penalties from the IRS that you will be subjected to.
Non-qualified withdrawals will be subject to a 10% tax on earnings, not on the total account value.
There are also a few exceptions that will allow you to avoid penalties.
If the beneficiary qualifies for scholarships, an amount equal to the scholarship may be withdrawn from the 529 savings account without penalty.
Another exception is choosing to enroll in the U.S. Military Academy. Because the Military Academy has different costs associated with enrollment than colleges do, your 529 plan might need to be used differently.
How To Make the Most Out of Your 529 Plan
If you're looking to make the most of a 529 plan for you or a family member, there are a few strategies that you should employ.
- Start saving as early as possible—the longer you save the more money your plan will have by the time college begins.
- Make regular contributions or set up an automatic contribution schedule where some money is taken out of every paycheck.
- Some states offer tax deductions for 529 plans. Reinvesting these tax benefits into your plan will help it grow faster.
- Work closely with a financial advisor to learn about all of your investment options.
