The Pros and Cons of 529 College Savings Plans

Paying for the college education of a child or grandchild is one of the most common goals of families. There are several ways to fund this effort, but one of the most popular is a 529 college savings plan. Prepaid college tuition plans are simple but not very flexible. Putting money into a regular savings account maximizes flexibility but offers no tax advantage. 529 savings plans by contrast offer both considerable flexibility and tax advantages.

How 529 Plans Work

529 plans are named for Section 529 of the federal tax code but are sponsored by the states and operated by financial services companies. Pre-paid college tuition plans are also covered in Section 529 and can be a good choice but are not as versatile as 529 savings plans. Money deposited into a 529 savings plan can be invested and if used properly, no taxes are payable on any of the earnings or withdrawals. “Used properly” means that the withdrawals are spent on certain “qualified” higher education expenses such as tuition, fees, room and board, books and supplies and a few other expenses incurred at a qualified university. (For related reading, see: 5 Secrets You Didn't Know About a 529 Plan.)

Most schools you know are “qualified” meaning the institution is eligible to participate in a student aid program administered by the U.S. Department of Education. In addition, the new tax law allows up to $10,000 per student per year to be used for some K-12 expenses including private school tuition. This seems simple enough but there are some quirks. Recently we saw West Virginia on a list of the best 529 plans and on a list of the worst 529 plans. This contrast is not all that odd. Other states have found themselves on both the best and worst lists over the years. How is that possible?

One reason is because the lists are created by different entities and they may use somewhat different criteria in their evaluations. The real culprit, however, is because the lists are evaluating two different plans, as many states have more than one plan. Usually when this is the case, one plan is sold by brokers and the other is sold directly to consumers. The plans sometimes have different investment options but the biggest difference between plans is usually the cost. Plans sold by brokers typically have higher costs to cover commissions paid to the sellers and their firms. The costlier, broker sold West Virginia plan is on the “worst” list while the direct purchase plan made the “best” list. 529 savings plans are unique and offer both opportunity and potential problems. Below are a few of the most prominent pros and cons of 529 savings plans.

The Pros

Tax-free withdrawals: A major benefit these plans have is the tax-free nature of withdrawals used for college expenses. This benefit is available to all taxpayers regardless of income.

Adult control: The owner of the plan is usually a parent of the student named as beneficiary. The owner controls the account. Junior will not be able to empty the account to buy a sports car on the way to campus. Parental ownership is also better when it comes time to apply for financial aid because parental assets are treated differently than student assets. (For related reading, see: How 529 Plans Impact Financial Aid.)

Geographic freedom: You can use the savings plan of any state regardless of which state you live in or in which state the student attends college.

Family flexibility: If the beneficiary does not attend college or use all the funds in the plan, the beneficiary can be changed to a family member of the beneficiary. There is no deadline as to when money in a 529 savings plan must be used. If there are funds remaining, it should be possible to avoid tax and penalties by continuing the plan and using the funds for a new beneficiary. This flexibility is important because not using the money for higher education results in high rates of tax. Because “family member” is defined quite broadly, the potential for a 529 savings plan to be used for more than one student or even more than one generation is significant.

Flexible gifting plus gift/estate tax advantages: Anyone can open a 529 savings plan and the plan can accept contributions from anyone. This makes these plans handy for families who have multiple members wanting to contribute. Those who wish to make larger contributions of $15,000 or more in a year can utilize the 529 plan’s unique five-year gifting feature which allows up to $75,000 (five years’ worth of gifts) to be made in one year without gift taxes.

Possible state income tax deduction: Contributions to 529 plans are made with after tax dollars so putting money in a plan won’t affect your current year taxes, unless you live in a state with state income tax. In that case, a deduction against state income tax (not federal income tax) is possible. With no state income tax in Florida, most of our clients will see no benefit here.

The Cons

Taxes and penalties: If you do withdraw earnings that are not used for qualified expenses at a qualified institution, the earnings are taxable plus a 10% penalty applies. To avoid this, you should keep records of exactly what was spent on college and be careful not to withdraw more than needed during the tax year. Some states have “recapture” rules. If you take a state income tax deduction and subsequently transfer the funds to a better plan in a different state, the state in which the deduction was taken can reclaim those deductions.

Limited investment flexibility: In some ways, 529 plans resemble a typical 401(k) plan. You are limited to the investment options within the plan. In the better plans, these options are low cost and sufficient in number to build a good mix of investments. However, unlike a 401(k) in which you can usually make changes whenever you like, the frequency of changes to the selections in a given 529 plan are limited. If an additional change is desired, you would need to move the funds to another state’s plan.

Complexities: Prepaid college tuition plans are simple but not very flexible. Putting money into a regular savings account maximizes flexibility but offers no tax advantage. 529 savings plans by contrast offer both considerable flexibility and tax advantages. However, given the special rules regarding gifting, rollovers to family, financial aid, possible state income tax deduction quirks, and other items unique to 529 saving plans, there is plenty of potential for mistakes to be made. (For more from this author, see: How to Avoid Gift Taxes.)


Disclosure: Dan Moisand’s comments are for informational purposes only and are not a substitute for personalized advice. Consult your advisor about what is best for you.