The Pros and Cons of Using a 529 College Savings Plan

Saving for college with a 529 plan offers several advantages over other forms of investments or savings accounts, yet may not be suitable for everyone.

Investments and earnings held within a 529 plan can be tax-free if used to cover qualified education expenses; non-qualified withdrawals, however, may incur federal income taxes and an additional 10% penalty tax.

Taxes

529 plan earnings can be tax-free if used to cover qualifying educational expenses, unlike many investment accounts. If withdrawn for noneducational expenses instead, federal income taxes plus an additional 10% penalty on earnings (not contributions) will apply; you may also lose any state tax deductions and credits associated with contributions you made to this plan.

Assets held in a 529 plan owned by parents will have less of an effect on student financial aid, typically decreasing need-based assistance by up to 5.64% of its value.

Fees associated with 529 savings plans can have a profound effect on their returns, so make sure your plan offers low fees with multiple investment options and strong performance records. It may also be worthwhile considering opening a custodial account which doesn't limit contributions but still offers tax-free growth for earnings on all investments.

Fees

Note that 529 plans typically offer lower fees than mutual funds; however, account maintenance charges, investment fees, sales charges and other expenses still incurring as part of your potential returns should be carefully examined before selecting one to invest in. "Be sure to look into each plan's fees to make sure they're not too high," suggests Busse.

An effective way to minimize investment fees may be investing in a state-sponsored plan, which typically offers more affordable fees compared to national or independent plans. Furthermore, try finding one with limited investments available per category in order to narrow your options and limit exposure to risk.

If you are a moderately wealthy investor, a 529 plan may offer significant tax benefits and allows for annual gifts of up to $15,000. By making annual gifts of this size to the account, it will waive its annual maintenance fees while giving tax benefits in both categories; you also potentially avoid estate taxes on your gift and withdrawals are federally tax-free if used towards qualified education expenses such as tuition, fees, room and board, books and supplies.

Investment Options

529s grow tax free and withdrawals used for qualified education expenses such as tuition fees, room and board costs and some technology and equipment expenses are tax-free withdrawals. Each state selects its own plan administrator - typically a large, well-known brokerage firm - who oversees investments within that state plan administrator's jurisdiction. These investment options range from static portfolios that limit risk to age-based options that become increasingly conservative as beneficiaries get closer to college age.

State fees may reduce overall returns from 529 plans held by parents; assets held in such plans could impede eligibility for need-based financial aid, though to a lesser degree than if it was owned directly by a student.

Investing your own funds may present its own set of difficulties and risks; any withdrawals for noneducational uses could incur income taxes and penalties of 10%, making managing them on your own a significant challenge. This may deter investors who prefer managing their investments themselves and managing investment risk themselves.

Flexibility

An advantage of 529 accounts over other types of educational savings accounts such as an UGMA or UTMA account is that parents maintain control over them. Children won't gain access to the funds and use them for anything other than education-related costs; additionally, beneficiaries can be changed without incurring taxes or penalties, making these accounts useful if one child's college plans change suddenly.

An additional advantage of 529 plans is their absence of negative effects on federal financial aid applications, contrary to what some might assume. While FAFSA takes account of plan investments when calculating expected family contributions (the parental asset rate being assessed at 5.64 % instead of the higher rates often applied against cash or mutual funds).

Anyone 18 or over with access to either their Social Security number or Tax ID can open a 529 plan for themselves, their spouse, children, friends and relatives; however they are only eligible to contribute up to the annual gift tax exclusion amount.

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