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Key takeaways
- 529 plans are investments used to save for educational expenses.
- Not all states offer tax credits and deductions.
- 529 plans are excellent for some but are not optimal for every family.
- If you’re unsure if your child will attend college, how much you may need or prefer a more hands-on approach with your investments, a 529 plan may not be the best choice.
A 529 is a state-sponsored investment plan to help parents and other adults fund a child’s future educational costs. The account beneficiary can make tax-free withdrawals to pay for eligible education expenses.
However, a 529 plan may not be the best choice if you’re not sure if your child will go to college, how much money your child will need for college or if you like to be more hands-on with your investments.
How does a 529 plan work?
Parents typically open 529 plans on behalf of a child or, in some cases, a grandparent for a grandchild. Account owners can contribute to the account and watch it grow tax-deferred.
Funds in a 529 plan can also be withdrawn tax-free as long as they’re used for qualified educational expenses, such as*:
- Tuition
- Fees
- Room and board
- Books and housing at colleges and universities
- Technical and vocational schools
- Apprenticeship programs
- Private K-12 schools
*Qualified expenses vary by state.
The tax-free use of the funds is restricted to educational expenses only, so if your child chooses not to pursue an educational path, you’ll incur taxes and penalties when you withdraw the funds.
If you open a 529 plan early, you could see sizable growth in your account by the time your child pursues their postsecondary education.
Individual states administer these plans, but you’re not limited to the 529 plan offered by your state. If you’re an active investor, you’ll have no involvement in the investments the plan administrators choose to make. Some plans take a more conservative investment approach, meaning your funds may grow at a slower rate.
Pros and cons of a 529 plan
While a 529 plan is one of the more well-known savings vehicles for college funds, there are benefits and drawbacks to consider.
Benefits of a 529 plan
- Tax benefits. In more than 30 states, account owners can receive tax credits or deductions when they contribute to a 529 plan.
- Earnings grow tax-free. The money in a 529 plan grows tax-free and can be withdrawn tax-free as long as it’s spent on qualified educational expenses.
- Beneficiaries can be changed.
- 529 funds can be used to pay student loans.
Drawbacks of a 529 plan
- Nonqualified expenses may incur penalties of up to 10%.
- Some state plans charge high fees that can eat away at your earnings.
- Investment choices may be limited.
- 529 plans could reduce the scholarships and grants your child could receive.
When is a 529 plan a bad idea?
A 529 plan is not always the best choice for every situation. There are times when other investments are a better fit.
- You’re not sure if your child will attend college. If you start a 529 plan when your child is young, you have no idea what their career interests will be when they graduate high school. If your child does not pursue additional education, you may lose all the tax benefits of the 529 plan.
- You’re not sure how much money you’ll need to save for college. In the 10-year period from 2010 to 2020, college tuition increased 31.4 percent. The average cost of tuition at a public four-year college or university was $7,132. In 2020, that figure jumped to $9,375. This does not include room and board costs, fees or books. This rising cost of education makes it difficult to know how much you should contribute to a 529 plan.
- You have investment experience and prefer to choose from a wide range of investment options rather than be limited to the investment strategy used in the state’s 529 plan.
- You would lose out on federal financial aid. Since a 529 plan could reduce the federal aid your child would qualify for, they may miss out on receiving federal Direct Loans or Direct PLUS Loans or grants, like the Pell Grant or Federal Supplemental Educational Opportunity Grant.
States that don’t offer 529 tax credits and deductions
Nine states do not offer 529 tax credits or deductions. They are:
- Alaska
- Florida
- New Hampshire
- Nevada
- South Dakota
- Tennessee
- Texas
- Washington
- Wyoming
Four states do charge income tax but do not have a 529 deduction. They are:
- California
- Hawaii
- Kentucky
- New Hampshire
Alternatives to 529 plans
If you don’t think a 529 plan is the best option for you and your child, you can consider alternative options.
Brokerage account
A brokerage account is an investment account where you can contribute money and invest it in the stock market. When you withdraw funds, you will owe capital gains taxes on any profits, though you can use funds for any purpose — not just an education.
Unlike with a 529 plan, no tax credits or deductions are available for brokerage accounts, which are also far more likely to impact your child’s eligibility for financial aid.
Roth IRA
A Roth IRA is a type of retirement account that uses after-tax dollars. You can withdraw contributions at any time without facing fees or penalties and withdraw without penalty if the earnings are used for educational expenses. The benefit of using a Roth IRA instead of a 529 plan is you’re not required to use the funds for educational costs, so it could be a good option if you’re not sure if your child will pursue secondary education or, if they do, how much money they’ll need.
However, a Roth IRA isn’t designed for college savings. It’s a retirement account, so any money you withdraw to pay college costs will eat into your retirement savings. Taking distributions may also hurt your child’s chances for financial aid.
Custodial account
A custodial account is a savings plan that allows a minor to take ownership of the account upon age 18 or 21, depending on each state’s rules. You can withdraw funds anytime if they are for the designated child’s benefit. When the child reaches adulthood, they can withdraw funds for any purpose.
Custodial accounts also offer tax advantages. Some earnings on the account are tax deductible. Once that threshold is reached, earnings are taxed partially at the adult’s and child’s tax rates.
The bottom line
While these programs have benefits, they also have drawbacks that make a 529 plan a bad idea for some families. Researching all the investment options before investing in a 529 plan is essential.
